Are Smarter People Better Investors?

On the Link Between Intelligence and Investment Outcomes

Photo: Pixabay

Are smarter people better investors?  Most of the traditional answers I have read on this suggest “No” or “not necessarily.”  For example, my colleague Ben Carlson wrote about how some of the smartest people in society (i.e. doctors, lawyers, engineers, etc.) also happen to make some of the worst investors due to their overconfidence.  Many of these highly educated individuals believe that their superiority in one field transfers over to investing.  Warren Buffett implicitly agreed with this when he stated:

You don’t need a lot of brains in this business.  I’ve always said if you got an IQ of 160, give away 30 points to somebody else, because you don’t need it in investments.

You might counter Buffett’s argument by pointing to Renaissance Technologies, the best performing hedge fund on Earth with its army of math and physics PhDs.  Touché, you’ve done your homework.  But, you would also have to acknowledge Long-Term Capital Management (LTCM), the team of Nobel Prize winning economists that blew up their hedge fund in September 1998 and almost took down the financial system with it.

You will go back and forth, back and forth without a definitive answer.  My problem with this kind of thinking is that it is all based on selection bias and low sample sizes.  Yes, I know investing is about behavior and not just intelligence, but what if that behavior is correlated with intelligence?  What if EQ and IQ are related?  Rather than imagining how intelligence affects investment performance and providing individual examples, I want to know, “What does the data say?”

I did some digging and found a working paper based on male investors from Finland that provided an answer.  Specifically, the researchers found that:

High-IQ investors are less subject to the disposition effect [i.e. selling winners and holding losers], more aggressive about tax-loss trading, and more likely to supply liquidity [sell] when stocks experience a one-month high. High-IQ investors also exhibit superior market timing, stock-picking skill, and trade execution.

The researchers were able to make these connections because all Finnish males are required to take IQ tests as a part of their military service and are required to report all of their investment activity for tax purposes.

Long story short:  On average, smarter people have better investment performance because they make fewer behavioral mistakes and pay lower fees.  There also seems to be some correlation between higher intelligence and market timing ability, but only in certain circumstances.

For example, their paper includes the chart below which shows how different individual investors entered and exited stocks during the DotCom bubble based on their IQ group [Note: You can assume Stanine 5 represents an average IQ of 100 with Stanine 9 representing a high IQ of 126.25 or greater (or 1.75 standard deviations above the mean)]:

What you will notice is that the lowest IQ individuals (Stanine 1-4) entered positions (green) nearer the top of the DotCom bubble compared to their more intelligent counterparts (Stanine 9) who were not entering (red) at the same time.

When I first saw this it made me think that there was such a thing as “dumb” money, but it looks like this applied only during the DotCom bubble.  As the paper goes on to state:

We also discovered that high-IQ investors’ stock purchases predict price increases but their stock sales say little about price decreases.

So, the “smart” money seems to know before a boom is about to occur, but has no predictive power over when things will crash.  As the authors note, almost all of their conclusions are consistent with prior academic work in this field.

Before you try to “Actually…” the paper, I will admit it has limitations.  For example, those Finnish males with below average IQs (Stanine 1-4) are under-sampled as investors since they represent 41% of the IQ sample, but only 24% of the investor sample.

Therefore, if we know that IQ is correlated with income and income is correlated with the ability to invest, then high IQ individuals will, on average, have more experience investing.  With that additional experience it wouldn’t surprise me that they would be better investors.

Despite the paper’s limitations, I liked it because it focused on a homogenous population with similar educational access (i.e. Finnish males).  In doing so, the researchers didn’t have to worry about the diverse set of societal factors found in countries with more heterogenous populations (i.e. the United States) and could instead focus on the contribution of intelligence to investment performance.

Lastly, the paper’s conclusions are not inconsistent with Warren Buffett’s “give away 30 points” quote, as the highest IQ group (Stanine 9) had an IQ of 126.25 or greater (close to Buffett’s recommended IQ of 130).  So while it is clear that smarter people tend to be better investors, this may only be true to a point.  Further research is needed.


Knowledge is Power

While it’s easy to read this article and say, “If I’m not smart then I won’t make a good investor,” I think this misses the point.  The reason why smarter people are better investors has to do with their investment knowledge, not necessarily their brains’ raw processing power.  Smarter people knew to avoid huge trading costs and other fees, they knew to be wary of entering markets at extremely high valuations (i.e. DotCom), and they knew about behavioral biases (i.e. the disposition effect).  Even their “superior stock-picking skill” seems to be partially explained by access to inside information as noted by the authors.

It’s better information all the way down.  And you don’t have to be smarter to acquire more or better information.  As Bill Gurley, the legendary VC, said in this incredible talk on career advice:

I can’t make you smartest or the brightest, but it is quite doable to make you the most knowledgeable.  It’s possible to gather more information than somebody else.

This is why, when it comes to personal investment decisions, knowledge is power.  So keep reading, keep learning, and keep studying the evidence.  It’s the smartest thing you can do to secure your financial future.  Thank you for reading!

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This is post 130. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

 
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14 Responses

  1. Anonymous commented on Jun 25

    Actually…..Nick, another great posting! Also, I wonder how competitive sports experience influences investing results. Then, there are the more mental sports (i.e. Buffett plays bridge), Chess, etc.

  2. Anonymous commented on Jul 02

    Excellent post. The researchers highlight many important points and it makes a lot of sense that people with higher income get more experience investing and are less prone to fear loss and chase profits. Also, it would not surprise me if intelligent people get more exposure to new trends and technologies through their work and professional networks.

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