Follow the Smart Money

If I had a dollar for every time I've heard the term "smart money" bandied about on financial television programs, I'd have a lot of ... smart money. It conjures up images of brilliant investors making ingenious purchases, but it more often refers to where big gobs of money are heading at this particular moment -- and the next moment, and the one after that.

And that money is not necessarily smart, because when investors trade frequently, their results suffer. A decade ago, for example, business school professors Brad Barber and Terrance Odean studied thousands of investors' trading behaviors and results. The average household had a net annualized geometric mean return of about 15.3%, compared with a market gain of 17.1%. But those households that traded most often only realized a 10% annual gain.

The conclusion? Frequent trading is "hazardous to your wealth."

So, what's the real smart money?

Be smart and index
While the talking heads spout on about minute-to-minute predictions, great fortunes have been built by people who bought into healthy, growing companies and then held on for the long haul. Warren Buffett, who built his entire fortune from scratch, has said that his favorite holding period is "forever."

But what about those of us who aren't Warren Buffett, who don't have a deep understanding of various industries, but who do believe in the future of American business? According to Buffett:

That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

The majority of managed mutual funds, which are how many investors diversify their investments, fail to outperform simple index funds. By being average, then, you'll be above-average. You'll outperform lots of Wall Street pros. Now that's smart!

Be smart and use stocks
Of course, you might aim to do even better than the market's return. If you do have a solid handle on a few industries, adding some individual stocks to your portfolio (perhaps in addition to an index fund) might very well be smart.

Check out the 20-year average annual returns for the following companies:

Source: Yahoo! Finance.

Compare those numbers with the S&P 500's average gain of just 6.3% in the same period (which was considerably higher before the recent 40%-plus market swoon). A $10,000 investment in a company that averages 12% growth over 20 years will grow to almost $100,000 in two decades -- an increase of nearly 10-fold.

The smart money buys and holds good companies.

Be smart and use funds
But what if you aim to outperform the market, but you don't necessarily feel confident picking individual stocks? Then the smart money looks for those few managed mutual funds that do consistently outperform the market.

How to find them? Look for

• Smart, long-term managers with impressive track records
• Low fees
• Low turnover

If you'd like some help finding funds like this, consider our Motley Fool Champion Funds investment service. It recommends at least one winner each month, and a free 30-day trial will give you full access to all of our past issues -- and all of our past recommendations. So turn off your TV and tune in to where the smart money is -- in index funds, individual stocks, and top-notch managed funds -- all held for the long run.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Best Buy is a Motley Fool Inside Value pick. FedEx and Best Buy are Stock Advisor selections. The Fool owns shares of Best Buy. The Motley Fool is Fools writing for Fools.