Saturday, January 20, 2007

Investing: What is hot money?

Hot money is investment money that rushes after established, well publicized rapid growth assets. Hot money usually rushes in once the financial media has begun to aggressively hype recent past performance of a particular investment. Usually in articles that read "6 hot funds you must own now!"

There are several problems with hot money:

  1. By the time an asset class or investment has achieved substantial growth it is often over valued or at least fairly valued.
  2. Hot money ends up paying a premium for the asset and increasing the market price even further.
  3. Hot money is usually the last to get in, just in time for the original investors to sell at a substantial profit.
  4. Asset classes tend to mean revert - this means what goes up, usually goes down, back toward the long term average; e.g. internet stocks went up in the late 90s, they went down in the early 2000s.
  5. Hot money leaps from trend to trend to trend - always late to the table, the best dishes already eaten.
  6. Hot money ignores value investments.
  7. If you followed mutual fund in-flows, you'd notice that after a strong returns the inflows shoot up, funds underperform their investment, performance drops and funds flow out. Think of Fidelity's Magellan fund as an example. Oddly, the funds with the lease inflows usually become the next year's leaders - all part of the mean reversion process.
  8. A friend of mine created a spreadsheet based on asset class inflows. He invested in the opposite asset classes (the ones with the least interest) and found that over time he had wonderful returns.
  9. After enough rush-in and let the sector crash around you experiences, many trend chasers give up on investing - handicaapping their future growth.

#9 is the biggest danger. After several ridiculous jumps into fast growth areas, a trend chaser may be discouraged from investing in the equities markets. A decision that will put the investor at long term risk due to insufficient returns from "safer" investments.

A better alternative is an asset allocation program with diversified investments.



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