Study: Smart Investors MUCH Better Stock Pickers than Dumb Investors

I came across a neat research paper from UCLA and a few others universities seeking to address the topic of whether investors with a high IQ actually exhibit superior investment performance over others.  This study strikes at the heart of the notion that stock picking is a random walk and no one investor can reasonably outperform a proxy index over time due to efficient market theory.  Based on the conclusions of this study, what efficient markets enthusiasts don’t consider is that not all traders are created equal.  It’s a long, painful read, (here) but here are some basic outcomes and interesting points:

The paper starts off with the following ominous, yet so-true statement:

“The behavioral finance literature finds that individual investors, on average, make major investment mistakes. They under-participate in the stock market, grossly under diversify, enter wrong ticker symbols, buy index funds with exorbitant expense ratios, and lose when actively trading in the stock market.”

This begs the question as to whether more intelligent people make more rational, better-performing decisions.  While the study’s data set was from trading in Finland and not the US (or which many readers here hail from), Finland is probably actually MORE suitable to a study of this sort for the following reasons:

• The Finnish school system is remarkably homogeneous: all education,including university education, is free and the quality of education is uniformly high across the country.
• The country is also racially homogeneous and compared to other countries, income is distributed fairly equally.
• These factors make it more likely that differences in measured IQ in Finland reflect genuine differences in innate intelligence.

So, Are Smart Investors Better Stock Pickers?

• They found that high IQ investors’ stock purchases subsequently outperform low IQ investors’ purchases by “an economically and statistically significant margin” (more on this below), particularly in the near future.
• They also found (interestingly) that High IQ investors obtained lower trading costs.  i.e. the market orders of smart investors are placed at times when bid-ask spreads temporarily narrow.
• The results indicate IQ’s influence on stock-picking skill is particularly strong for returns measured two days later, when the purchases of high IQ investors outperform the purchases of their low IQ peers at an annualized rate of about 11% per year.
• However, high IQ investors’ purchases also earn superior and significant returns up to one month in the future.
• The benefit tends to dissipate after approximately 1 month.

Interesting Study Observations:

• In looking at the data, it’s evident that high IQ traders have larger portfolios (this would tend to make sense that smarter people tend of have more money), but they also conduct more trades.  Everything we’d been taught over the years was that smart investors buy and hold, while dummies traded.  The data indicates otherwise – both from a standpoint of what smart investors do AND from a performance standpoint.
• The final graphs also indicated that high IQ traders not only had better buy executions, but also knew when to sell.  Many tenured traders will highlight that knowing when to sell is more than half the battle (not just 50% of the battle).

My Thoughts on Smart vs. Dumb Investors:

I know my trading portfolio has performed marginally better than the S&P 500 each year over the past few years prior to expenses.  There is no good proxy to compare with though since I generally trade riskier stocks/ETFs, emerging markets ETFs and I hedge with options (see how stock options work) to protect from rapid downside moves such as what we saw in 2008-2009.  With expenses, it’s hit or miss each year.  This is encouraging in that if I were trading with a big-time investment portfolio, perhaps I would routinely outperform when trading fees were marginalized due to scale.  Conversely, in my situation, it begs the question as to whether the time and effort that go into research and executions are really worth it.  I like to think that as I hone my skills over decades of experience it will have a meaningful contribution to my net wealth and benefit my family.  But with only 10 years of active trading to draw on (and not knowing my IQ!), perhaps there’s no way for me to draw any meaningful conclusions.

I don’t know what my IQ is.  My parents would never tell me.  I suspect either they didn’t remember or they didn’t think I’d like what I heard.

Regardless, I’m curious to hear what your thoughts are on the study, whether you can draw any meaningful conclusions from the study and whether it would influence your affinity for trading.

Tagged as: Smart Investor, Stock Picking