Smart people own more stocks: study

By 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 equity 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 few as 51% of American households own them, a 2009 study by the Federal Reserve found. Individual investors have pulled record cash out of U.S. 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, California-based Research Affiliates LLC. About US$85-billion is managed using his firm’s strategies. “You can generalize 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.”

Military Records

Mark Grinblatt of the University of California, Los Angeles, Matti Keloharju of Aalto University in Espoo and Helsinki, Finland, 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 US$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.

‘Really Saddened’

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

Returns from the stock index have dwindled to about 0.6% 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 US$219-billion 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 standardized test. To me, it really fails in the truth-in-advertising arena.”

‘So Strong’

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 10% 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 in a phone interview. “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 maximize returns for a certain amount of risk. The 2009 study by the Fed found that 51.1% of American families own stocks directly or indirectly, and of those who do, 36% have shares in one company.

‘Difficult to Justify’

“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 minimized, the authors said. Draftees were about 20 years old when they were given 120 questions in math, 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.

Robert Shiller

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

Finnish draftees aren’t representative of typical investors, said Wells Fargo’s Jacobsen. IQ is a function of culture and shouldn’t be generalized across borders, he said. The authors also failed to discuss whether the test given to the soldiers was a valid way to grade thinking.

“They should’ve been at least honest about it from the outset, and say, ‘Hey, this is not about IQ and investing, this is about Finnish males that took this particular test,’” he said in a telephone interview. Finland’s lack of ethnic diversity “invalidates it for extrapolating it to other cultures,” he said. “That makes it that much more inappropriate to draw inferences from it about other cultures.”

Fund Outflows

Owning stocks isn’t always the best option or even a good idea, according to Mark Luschini, chief investment strategist at Philadelphia-based Janney Montgomery Scott LLC, which manages US$54-billion. Investors pulled money out of mutual funds that buy U.S. stocks for a fifth straight year in 2011, the longest streak in data going back to 1984, according to the Investment Company Institute in Washington. Last year, an estimated US$135-billion was withdrawn, the second-highest annual total after 2008, preliminary data from ICI show.

“I hate words like always or never,” Luschini said. “It’s always important to consider owning stocks, but in the context of what’s important to your particular circumstances, it’s not so much a question of whether to own them, but to what degree you should be exposed to them. For a couple who is retired and is more in the wealth preservation mode, perhaps they’d want to dial down their exposure.”

Finnish soldiers who scored lowest on the test and still owned stocks usually made the worst asset-allocation decisions, the authors wrote. They purchased too few companies, bought in more volatile industries, and got the worst bang for the buck as measured by the so-called Sharpe ratio, which adjusts return for risk taken. As a result, they were less likely to buy more shares in the future, the researchers said.

Social Policy

The study’s authors said the findings have implications for social policy. Avoiding stock investments cuts returns and may widen income gaps, they said. Individuals scoring lowest on the tests who still owned equities earned as much as 33 basis points, or 0.33 percentage point, a year less than the highest scorers. One way governments could promote better savings might be with plans that let people opt out of stocks, like 401(k) plans, as opposed to opting in, said Keloharju.

“If you look at these people over time, people with higher IQ scores and stocks become wealthier and wealthier at a much faster rate than people with lower IQ scores,” said Linnainmaa. “It makes them worse off in the long run, even more so than the difference in income.”

Financial Education

Hsu of Research Affiliates said an explanation for why draftees with lower test scores owned less stock is that they found it harder and more expensive to receive financial education. Getting people information on investing at a younger age may help limit the disparity, he said.

“The costs to achieve that are certainly higher if someone isn’t providing that at an earlier stage in one’s education,” said Hsu. “If we could provide advice, or provide education, to help reduce the cost of acquiring financial knowledge, that would seem like a good thing.”

The paper is part of a broader debate about the role individual characteristics such as affluence and education play in investor actions. In the 1980s, so-called behavioral economists broke away from theorists such as Sharpe, who tended to think of all investors as rational.

Greg Davies, head of behavioral finance at Barclays Wealth in London, said his team tries to gauge clients’ risk tolerance with personality profiles and investment strategies that appeal to “emotional needs.”


“As advisers, of course, we see our role in overcoming the irrational, emotional, inaccurate elements on behalf of our clients,” said Davies. “But the implications of this for the mass markets are much greater.”

Markowitz said the argument that intelligence and personality sometimes trump rationality in guiding investors has little bearing on his work. His theory comes down to the view that anyone hoping to get the highest payout at the lowest risk should broaden their asset ownership.

“It’s advice for the individual investor,” Markowitz, 84, said in a telephone interview. “I am delighted to learn the more intelligent a person is, the more likely they are to act in the spirit of what I wrote.”

Bloomberg News

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