Saturday 16 December 2017

It's brains, not money, that determine investor decisions on share investments

Ksenia Galouchko and Katia Porzecanski

THE smarter you are, the more stock you probably own, according to researchers who say they found a direct link between IQ and stock market participation.

Intelligence, as measured by tests given to 158,044 Finnish soldiers over 19 years, outweighed income in determining whether someone owns shares and how many companies he invests in.

Among draftees scoring highest on the exams, the rate of ownership later in life was 21 percentage points above those who tested lowest, researchers found. The study, published in last month's 'Journal of Finance', ignored bonds and other investments.

Economists have debated for decades what they call the participation puzzle, trying to explain why more people don't take advantage of the higher returns stocks have historically paid on savings.

As little as 51pc of American households own them, according to a 2009 study by the Federal Reserve. Individual investors have pulled record cash out of US equity mutual funds in the last five years as shares suffered the worst bear market since the 1930s.

"It's what we see anecdotally: higher-IQ investors tend to be more willing to commit financial resources, to put skin in the game," said Jason Hsu, chief investment officer of Newport Beach.

"You can generalise a whole literature on this. It seems to suggest that whatever attributes are driving people to not participate in the stock market are related to the cost of processing financial information."

Mark Grinblatt of the University of California, Matti Keloharju of Aalto University in Helsinki and Juhani Linnainmaa at the University of Chicago compared results from intelligence tests given by the Finnish military between 1982 and 2001 to government records showing investments the draftees later held.

They found the rate of stock ownership for people with the lowest scores trailed those with the highest even after adjusting for wealth, income, age and profession.

Three years after $37 trillion of global share value was erased in a 16-month bear market, not everyone considers limiting equity ownership to be a mistake. Nassim Nicholas Taleb, author of 'The Black Swan', said in October 2010 that investors should sue the Swedish Central Bank for awarding Nobel Prizes to economists such as William Sharpe for theories that made it seem like stocks were safe. He declined to comment on the study.

The Standard & Poor's 500 Index has gained 9.8pc annually, including dividends since 1926, compared with 5.7pc for US Treasury bonds, according to Ibbotson Associates, a research unit of Chicago-based Morningstar.

Returns from the S&P 500 have dwindled to about 0.6pc a year since the end of 1999, and investors had two opportunities to sell after losing more than one-third of their money, in October 2002 and March 2009, data compiled by Bloomberg show.

"When I saw this paper, I was really, really saddened that it would actually get published," said Brian Jacobsen, who helps oversee $219bn as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin.

"What they basically do is look at a very specific subset of the world's population and try to infer how this group of 19 and 20-year-old Finnish males did on a particular standardised test. To me, it really fails in the truth-in-advertising arena."

While intelligence influenced things that might naturally increase equity ownership such as wealth and income, the authors said IQ determined who owned the most stocks within those categories as well.

Among the 10pc of individuals with the highest salary, "IQ significantly predicts participation" in the stock market, they wrote. For example, people in the highest-income ranking who scored lowest on the test had a rate of equity market participation that was 15.7 percentage points lower than those with the highest IQ.

"If you look at the significance of IQ related to other factors like income or wealth, certainly it plays a very large role," Keloharju, a finance professor at Aalto, said.

"It's very difficult to get around that problem, but the results are so strong here. We are playing with lots of different controls and lots of different specifications, and all the time things work really well."

American economist Harry Markowitz won a Nobel Prize in 1990 for his theory that owning a larger variety of assets tended to maximise returns for a certain amount of risk. The 2009 study by the Fed found that 51.1pc of American families own stocks directly or indirectly, and of those who do, 36pc have shares in one company.

"It's difficult to justify why someone wouldn't invest in the stock market, knowing what a good deal it has been," said Linnainmaa, a co-author of the study from the University of Chicago's Booth School of Business.

"The classical explanations for non-participation have been participation costs. It's not just that it may be expensive to buy stocks and mutual funds, but people may not have enough knowledge about them."

Finnish soldiers were an ideal sample because differences in race, schooling and market access are minimised, the authors said. Draftees were about 20 years old when they were given 120 questions in maths, language and logic.

The authors divided the results into rankings and compared them with stock-ownership records. People who don't serve in the country's military such as women weren't in the sample.

"There is an older literature on whether SAT scores of an investment manager's college helps predict his or her success," said Robert Shiller, an economics professor at Yale University and co-creator of the S&P/Case-Shiller home-price index. "This paper has a much better measure of intelligence," and the "results are therefore a significant advance", he added.

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