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Recent study draws correlation between education and wealth

Mon, Dec 13, 2010

The latest AAII Journal issue cites the results of a recent study by the RAND Corporation, that draws a correlation between a couple’s education and wealth levels.  In particular, the study found that

when both spouses answer [three numeracy-related] questions correctly, wealth is $1.7 million – when neither spouse answers any question correctly, household wealth is about $200,000.  Furthermore, there was a direct correlation between math skills and stock allocations.  Couples with higher math skills had a greater proportion of their portfolio allocated to stocks. 1
 Let’s examine the results and implications of these findings.  There are essentially two observations being drawn by the study.  The first is that there is a correlation between education and wealth (perhaps “net worth” would have been a preferable term to use than”wealth.”)  This observation is not surprising since degrees of higher learning generally lead to higher paying occupations, advancement and job security.  No big surprise here.  Well at least not until the recent great recession – I’m sure you’ve come across the spate of articles these days citing how college grads without job offers are starting their own companies.

The second observation is also not surprising but it is unfortunate.  It shows just how influential the so-called “knowledge” of the investment advisory community can be as well as how gullible smart couples are regarding their investment portfolios.  It seems as though the investment advisory community is still trying to console and brainwash its clientele into thinking that stocks should comprise the majority chunk of one’s overall investment allocations.  Advisors typically point to the renowned “king of the mountain” chart by Ibbotson Associates that shows how stocks pummel all other asset classes (investment grade bonds, commodities, and real estate) over long periods of time.

But have investors been informed about the reward to risk ratios of these asset classes?… that stocks are 4 times as risky as investment grade bonds? … that the “optimal” (admittedly a dangerous term when it comes to investing)  reward to risk allocation of stocks to bonds in a qualified retirement account actually suggests a majority weighting to investment grade bonds rather than stocks?… And how about the fact that in practice, the average individual investor (no matter how educated), only manages to take 35% of the average annual returns from stocks (which is about 10%)? 2

What is most upsetting when you read the two findings of the RAND study side-by-side, is that you can easily be duped into thinking that you should be more heavily weighted to stocks – because educated couples have allocated in this manner and educated couples have achieved significant levels of wealth.  But notice that the study says nothing about the investment performance results of these smart couples (especially over the past 3 years).  If educated couples were heavily allocated to stocks (as were the academics and efficient market theorists over at DFA/ – they probably got trounced by the recent bear market.  If this is indeed the case, and if the RAND study is valid, then the wealth created by the educated wealthy was not due to investment performance at all.  More likely, salaries, bonuses and possibly inheritance played more key roles in the build-up of net worth among educated couples than investment performance.

There may even be an inverse correlation between investment performance at the highest levels of education.  The tragic implosion of John Meriwether’s Long-Term Capital in 1998 comes to mind, for example.  As examined by Roger Lowenstein in his bestselling book entitled When Genius Failed: The Rise and Fall of Long-Term Capital Management, the author notes that the high levels of intellectual arrogance exhibited by Meriwether’s team of fund managers (which included two Nobel prize winning mathematicians), was one of the principal causes of the firm’s demise:

Unfortunately, uncertainty, as opposed to risk, is an indefinite condition, one that does not conform to numerical straitjackets.  The professors blurred this crucial distinction; they sent their mathematical Frankenstein gamely into the world as if it could tame the element of chance itself.  No self-doubt tempered them; no sense of perspective checked them as they wagered such staggering sums…If Wall Street is to learn just one lesson from the Long-term debacle, it should be that.  The next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect memory of the past is said to quantify the risks in the future, investors should run – and quickly – the other way.3
  Fortunately, not every educated couple suffers from hubris to the extent that the geniuses at LTCM did.  A periodic review of Lowenstein’s book would do much to help investors stay humble and proactive - qualities that should be the focus of the next RAND study – and specifically, how these character traits (rather than levels of education or certification) affect investment performance.

1 “Financial Decision Making and Cognition in a Family Context”, The Economic Journal, 120 (November 2010)
2 The DALBAR Study, Quantitative Analysis of Investor Behavior, March 2010.  (Please see the About page on the site for further discussion about these findings).
3 Lowenstein, Roger.  When Genius Failed: The Rise and Fall of Long-Term Capital Management.  New York: Random House, 2000.

Disclosure: I am long IWS.