Are smarter people better investors?
Although there’s been considerable debate over just what intelligence quotient (IQ) tests actually measure, studies have suggested that people who achieve higher scores are more likely to do well in school, earn more money and even live longer.
But does having a high IQ help when it comes to investing in the stock market? The answer, according to recent research, seems to be "yes" — with a few caveats.
A research team led by UCLA finance professor Mark Grinblatt concluded that people with relatively high IQs typically diversify their investment portfolios more effectively, and invest more heavily in stocks than those with lower IQ scores.
Those with higher IQs also tend to favour smaller-capitalization and value stocks, which tend to beat the broader market over time.
Remember, the name of the game is to choose asset classes that may go up when the others go down, and vice-versa. A well-diversified portfolio will grow more effectively as a whole over the long term.
“Compounded over many years, this return difference could contribute to the wealth gap between low- and high-IQ individuals to a greater extent than wage differences,” Grinblatt suggests.
He came to that conclusion after dissecting a database following Finnish investors over a 20-year period.
Why Finland? First, Finland requires that all able-bodied young men perform mandatory military service. As a result, the researchers were able to obtain entry-level test scores for cognitive functioning in mathematical, verbal and logical skills, which were used as an indicator of IQ.
Second, all Finnish taxpayers are required to report their investment portfolios to the government as part of their annual tax filings. So, it was fairly easy to determine what these people ended up doing with their money.
The researchers then took these IQ scores and compared the investment results the conscripts — most of whom were about 19 or 20 years old at the outset — were able to achieve after they’d completed their tour of duty.
Their conclusion: Most of those in the perceived “smarter” segment came out ahead.
It’s not that those with higher IQ scores were blessed with any particular stock-picking prowess, but they were more likely to construct portfolios with better risk/return profiles than their lower-scoring peers.
Low-IQ investors also tend to make more mistakes, the research suggests, which often deters them from further participation in the stock market. In short, they tend to panic when things get rocky — never to return.
At the same time, those in the low-IQ group that do remain invested don’t diversify, are less likely to include mutual funds in the mix and tend to be attracted to big-name stocks that are making headlines.
High-IQ investors, on the other hand, do much better because they moderate their risk with better diversification, trade less, and maintain broader exposure to stocks of all types.
Unfortunately, the study doesn't take into account whether the latter group subsequently invested in other asset classes that might prove equally attractive, such as bonds or commodities. As well, no women were included in the sample.
Nor are a group of Finnish draftees necessarily representative of typical investors with broader backgrounds, particularly when you’re trying to generalize across borders.
But the research does reinforce a few important guideposts. First, anyone hoping to get the highest payout at the lowest risk should broaden their asset class choices, lengthen their timeframe, and — for the most part at least — leave things alone.
In a follow up study using the same data, the researchers also concluded that high-IQ people are less subject to the "disposition effect," which suggests that investors are predisposed to hanging on to losers too long and selling winners too early.
Does that describe anyone you know? When your stocks take a hit, are you the type of person who can hold onto them until things improve? Or are you more likely to dump everything and get out while the going’s good?
High-IQ investors also are more aggressive when it comes to tax-loss trading, which is generally perceived to be a sophisticated strategy.
In other words, when they do sell, it’s driven by something other than panic. And, after harvesting the tax advantage, they’re more likely to buy back again to maintain their longer-run asset allocation.
Whether you’re actually smarter than the next guy is highly debatable. But there’s no question that having a reasonable amount of money in the stock market is a smart choice.
While it may not pay off year-over-year, it’s definitely the place to be over the long haul.
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