In a classic Seinfeld episode, George Costanza decides to do the opposite of what he would normally do in a given situation -- and he has one of the best days of his life.

Some investors may feel the same way after a bad investment decision: If they had done the opposite, everything would have turned out great.

If you have ever felt the same way, you may be experiencing the "dumb money effect." This term comes from the classification in the financial media of smart money and dumb money.

"Smart money" refers to large institutional investors or fund companies who have teams of analysts. They can stay abreast of what's happening in the market and are generally more informed. They also have the ability to act quickly on new information. That's why one investment approach is to "follow what the smart money is doing."

"Dumb money" refers to the average investor. Most individual investors cannot spend all day analyzing research reports or the global economy. Dumb money has no relation to intelligence. Even the smart money makes dumb decisions. It's more about access to information and the ability to act on it.

The dumb money effect relates to decisions made by the dumb money group as a whole. It's the tendency for people to buy investments when prices are rising -- and to sell them when prices are falling. In other words, it's about buying and selling a stock or fund at the worst possible time.

For example, the S&P 500I:GSPC has averaged returns of 9.5% per year (including dividends) for the past 20 years. Mutual fund returns averaged 1.0% to 1.5% less than the S&P 500. This largely reflects the fees charged by money managers.

But average investors generally earn 1% to 2% less than what mutual funds average. In other words, over the same 20-year period, the average investor would have earned 2.0%-3.5% less than the overall market each year.

There are few investors who just buy and hold. It's too tempting to try to outsmart the market. But this often leads to poor returns, because of the tendency of investors to buy after prices have already gone up (because they're optimistic) -- and to sell after prices have fallen (because they get scared).

The dumb money effect is so common and predictable that many markets have so-called "dumb money indicators." Contrarian investors use these indicators to see what the dumb money is doing, so they can do the opposite.

An important market force that the smart money understands, and the dumb money often ignores, is mean reversion, the fact that asset prices tend to return to long-term average trend levels over time. So, if a stock is trading above its historical average valuation levels for a time, mean reversion says it will eventually fall and return to its average valuation levels. Conversely, it will eventually go up if it is trading below average valuation levels.

Smart money more often has the patience and discipline to profit from mean reversion. But dumb money is often on the wrong side of it.

Here's how to avoid the dumb money effect:

    Study the history of the stock, or other investment, you plan on buying. When you see what it's done in the past, you're in a better position to profit from mean reversion. Sometimes that can involve waiting until the right time to enter.

    Study what the investment looks like now, and what that tells you about potential future returns. And don't base your decision on recent price performance. Base it on the fundamentals of the company.

    Based on its history and present situation, you can make an educated guess of how it should do and what your exit price will be. Have a well-informed plan and stick to it.

    By following these three steps you might find yourself doing the opposite of the dumb money crowd, or what you yourself might have done previously. But as we've shown, that will probably be to your advantage.

    Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in your inbox every day, for free.

    This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.