How Smart People Invest

by: Ploutos

Summary

Academic research demonstrates the strong linkage between IQ, the level of stock market participation and investment performance.

How do higher IQ investors portfolios differ from lower IQ cohorts, and how do these differences impact wealth?

Seeking Alpha readers should be able to glean information from this exemplary scholarly work by the researchers referenced herein to examine their own portfolios.

A pair of papers published in the last several years by a trio of international academics strongly links IQ to successful investing. What portfolio characteristics were shared by the more intelligent members of the population? Higher IQ cohorts were more likely to participate in the stock market, held more diversified portfolios, had higher exposures to systematic factors that have historically boosted risk-adjusted returns, and minimized tax and transaction costs.

The authors of these articles, Mark Grinblatt of UCLA, Juhani Linnainmaa of the University of Chicago (a former professor of mine), and Matti Keloharju of Aalto University in Finland, concluded in their research that people with higher IQ's tend to participate in the stock market more often, hold more diversified portfolios, and earn higher risk-adjusted returns than their lower IQ cohorts. Seeking Alpha is a site dedicated to making its readers more intelligent investors, so examining how the more intelligent members of a society are able to earn higher returns on their money seems like a more than worthwhile exercise.

While it makes intuitive sense that gains accrue to smarter investors at the expense of weaker investors in active investment management, empirical evidence attesting to this fact is difficult to come by. How smarter investors are able to glean higher market returns would be important information for all market participants. In IQ and Stock Market Participation, the authors took their research on these questions to Finland to find answers. Why examine a country with roughly the population of Minnesota? Three reasons: military service is compulsory in the sparsely populated Nordic nation, and I.Q. test scores are available for all conscripted males in the country; the nation has a wealth tax that requires its citizens to report their investment portfolios to the government; and, authors Linnainmaa and Kelohrju share a Finnish heritage. These factors combined to form an expansive dataset to test the linkage between intelligence and investing.

Of course, intelligence is linked to many other factors including income, quality and extent of education, and family upbringing. The authors attempted to control for these variables to more directly link intelligence and investment performance. The results are astounding. When IQ's are distributed into cohorts ascending by relative score, stock market participation is linked monotonically to IQ. Individuals with the lowest IQ scores invest least; the second lowest IQ cohort invests the second least, and so forth. In every below average IQ cohort, non-participators exceeded market participants, while in every above average IQ cohort, market participants were more prevalent than non-participants as graphed below.

Source: Journal of Finance - Grinblatt, Keloharju, Linnainmaa (2011)

Controlling for educational attainment, birth year, income, wealth, occupation, native language, marital status, and employment status, the coefficients related to IQ were strikingly significant because of both their magnitude and ordinal relationship. The IQ effect is more closely linked to stock market participation than even income, which indicates cognitive ability is a larger barrier to participation than available funds. Wealth, controlling for the same variables, is more significant than IQ in predicting stock market participation, but given the strong performance of Finnish stocks in the 1990s, the wealth factor could be the result of participation and not a causal factor.

The study also documented that low IQ investors are likely to experience a more adverse risk-return tradeoff than the higher IQ cohorts due to inferior diversification. High IQ individuals were more likely to hold a greater number of stocks and diversified mutual funds, with mutual fund ownership again increasing monotonically with IQ. Higher IQ cohorts were also more likely to pick value stocks and small cap stocks, which academic literature has shown outperform high growth stocks and large cap stocks respectively when adjusted for risk. High IQ participants also had lower-beta portfolios that lower-IQ participants. For those scoring at home, value, the size factor, and low volatility anomaly are three of my five tips to outperforming the S&P 500 (NYSEARCA:SPY).

In IQ, Trading Behavior, and Performance, using the same expansive Finnish dataset, the authors found that higher IQ investors are also effective in minimizing taxes and transaction costs. Lower IQ investors were more predisposed to the disposition effect, a behavioral anomaly where investors are more apt to sell investments that have risen in value and hold those that have fallen. Conversely, higher IQ investors were more aggressive about tax-loss trading. Higher IQ investors also had better trade execution with tighter bid/ask spreads and order strategies that best fit the market liquidity environment.

Including direct investing and indirect investing through retirement accounts, only roughly half of Americans own stocks. Direct stock ownership outside of retirement portfolios is in the low teens and falling even as barriers to the stock market have fallen with technological advances. While low wealth levels account for some of the non-participation, there is still a considerable amount of the populace with the means to save who do not invest. With the emergence of discount online brokers, and the ubiquity of low cost index funds, the barrier to stock market investment has probably never been lower, but a considerable proportion of our society does not invest in the stock market. With non-participants earning lower returns on their savings than market participants over time, the divergence between low IQ and high IQ cohort's wealth will grow over time. These findings have important policy implications given the growing gulf between the poor and wealthy in our society.

That's the big picture view though. On a personal level, readers should assess whether they share the traits of high IQ investors.

Participate. Diversify. Understand factor exposures. Recognize behavioral biases. Minimize costs. No matter where you fall on the IQ distribution, those tips can make you an intelligent investor.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.