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Monday, 16 November 2009

Intelligence Can Seriously Damage Your Wealth

Cerebral Investors

In most walks of life intellectual superiority is generally viewed as something that gives the possessor an advantage over their fellow humans. Admittedly measuring intelligence is a pastime fraught with difficulty and hedged in contradiction but, even so, there are a few easy ways in which we can distinguish people who have better than average analytic abilities. Whether that’s the same as being clever is another matter, but it’ll have to do for the current considerations.

As investing itself is often viewed as a cerebral occupation, an area where the spoils fall to the smartest, we ought to expect to find a good correlation between intellect and returns. After all the calculation of alphas, betas, coupons, coefficients, efficient frontiers, adjusted earnings and the rest of the paraphernalia beloved of market gurus is pretty complex stuff. Of course this is a myth: simply being smart isn’t anywhere near sufficient to succeed in stocks.

Clever People and Index Funds

An eye-opening study on how investors choose index funds – Why Does The Law of One Price Fail? – selected a bunch of exceedingly bright people as its subjects, most being in the 98th and 99th percentiles of US SAT scores: to summarise, these people are pretty damn smart by normal standards. Moreover the participants were also decently incentivised to succeed at the investment task – which was to select the highest performing portfolio of S&P500 index funds.

Now, a moment’s consideration will show that the only real differences between one S&P500 index tracker and another are the fees they charge. Therefore the optimum portfolio choice should be one that selects the minimum fee fund. It’s simply not that tricky a decision. Anyway, as you can guess, the ├╝ber-smart respondents conclusively proved that being the brightest of the brightest is no defence against the behavioural powerhouse of psychological confusion that investing in stocks inevitably ensures.

Dumb Choices by Smart People

Rather than choosing on the basis of minimal fees they generally selected on the basis of long-run annualized returns – which were different between the funds because of different inception and reporting dates. Indeed, rather unkindly the researchers made sure that the highest cost fund had the best annualized return. In fact the subjects that paid the lowest fees were the least highly educated - although ironically this was because, having no idea what they were doing, they spread their investments equally between the available funds rather than because they were making intelligent and thoughtful decisions.

Let's emphasise that point. The dumber investors did better than the smarter ones because they didn't understand enough about what they were doing to be fooled into doing completely the wrong thing. Brain hurting yet? It gets worse...

The research also controlled for all sorts of possibilities in terms of the information provided to the subjects but critically avoided any mention of additional services offered by the funds. This ‘additional service’ argument – things like access to stock market information – is one of the reasons the fund industry uses for justifying additional costs and their investors’ seemingly stupid investing decisions. Only it turns it’s nothing to do with services which are simply a distraction used to justify excessive fees. People really are that stupid.

Real-World Choices

In the real world the researchers point out the situation is likely to be worse:
"Subjects apparently do not understand that S&P 500 index funds are commodities. In our experiment, fees paid are increasing in financial illiteracy. In the real world, this problem is likely to be exacerbated by the financial advisors whose compensation is increasing in the fees of the mutual funds they sell to their clients. When consumers in a commodity market observe prices and quality with noise, a high degree of competition will not drive markups to zero (Gabaix, Laibson, and Li, 2005; Carlin, 2009). Our results suggest that such noise helps account for the large amount of price dispersion in the mutual fund market."
Basically fund managers throw up a lot of chaff to confuse the return seeking investor and advisors, the researchers reckon, are probably incentivised to muddy the water some more. They also find that neither disclosure nor education seems to make much difference to these returns. This simply reinforces research we’ve looked at before (see Financial Education Doesn't Work and Disclosure Won't Stop A Conflicted Advisor) and as these are the most popular interventions the fact that they don’t work should be a matter for concern.

It also should be noted that the participants had above average financial literacy, so you can probably imagine what the effect of advisor bias and skewed fund marketing will do in the real-world. Of course, this study wasn’t using people with a particularly deep knowledge of the way markets work, so even though they were extremely intelligent this doesn’t clearly show that smarts don’t help in investing, only that untrained clever people don’t see clearly in the obscure investing universe.

The Investing Habits of Financial Professors

No, we have to turn to another study to show that even being well versed in investment lore can’t stop intelligent people acting just as dumb as the rest of us. Doran, Peterson and Wright carried out a study on finance professors, looking at their investment behaviour.

Obviously we’re talking here about a group of people who should have a decent understanding of the way markets work and of the theories behind them. What we find, however, is the usual mix of confusion between ostensible beliefs and actual behaviour: basically as a group the professors behave in much same behaviourally muddled way as everyone else.

A majority of the academics claim they don’t really believe in the Efficient Markets Hypothesis. However, a majority of them do invest passively, which either suggests that they secretly do believe in efficient markets and are too ashamed to admit it or that they reckon the extra effort involved in trying to beat the market isn’t worthwhile. Whether or not the professors believe that the markets are efficient – or not – turns out to make no difference as to whether they invest actively – or not. Instead the active investing decision seems to turn on each individual’s confidence in their own ability to achieve excess returns. Which, of course, is exactly what we’d expect to find in any standard cohort of investors.

Smart or Dumb, Makes No Difference

While it’s sort of encouraging to find that smart people who probably have better than average understandings of the ways markets work make the same mistakes as the rest of us and that untrained smart people are no better than anyone else at investing it does point up the psychological problems that underlie even relatively simple investing decisions. If clever people are confounded by these behavioural issues we can’t expect the huddled masses to do any better.

The behavioural weaknesses that underlie errors of investing judgement are not overcome easily. It takes effort and hard work to do so and it may well be that our passively investing professors who don’t believe in market efficiency have figured this out for themselves. Generally, though, most people are cannon fodder for clever marketing funded by unjustified fees, even when the fund does nothing but track an index. It seems being smart doesn’t help you avoid these traps but, of course, it may allow you to better justify your own stupid decisions.

Related Articles: Survivorship Bias in Magical Mutual Funds, Overconfidence and Over Optimism, B.F. Skinner's Stockmarket Slot Machines


  1. The underperformance is due to "subjects apparently do not understand" the nature of s&p index fund. It is stupid to draw from that the conclusion that intelligence is bad for investing.

    Put it in another way, suppose a bunch of monkeys randomly choose s&p index funds and out perform the smart subjects, can we draw the conclusion that the monkey must be better at investing? Even if their decision are random and skill played no part?

  2. All of the blog entries here are top notch. This one is especially wonderful. This is one of the most important blog entries I have ever read. The implications of this one are just breath-taking.

    Intelligence is a tool. Tools can be used for good purposes or bad purposes.So the question is not -- "Is this person (or this "expert") intelligent or not"? The question is -- "Is this person putting his or her intelligence to good use or not?" That's the entire deal.

    What determines whether we put our intelligence to use enhancing our returns or rationalizing poor choices? Our emotions! Emotion dominates in investing. Intelligence is important but secondary. You've got to get the emotions right or you will end up using your intelligence to defeat yourself rather than to help yourself.

    I only in part agree with the idea that getting one's emotions under control is "hard." It depends on how you mean it. It's not at all difficult. It's as easy as eating a piece of apple pie to get your emotions under control. You look at valuations. The extent of overvaluation tells you how emotional the market is at any given moment. That tells you what you need to know.

    However, there is indeed one sense in which taking this simple step is "hard." It usually cannot be done effectively by the individual investor acting alone. Our emotions are greatly influenced by what our friends and neighbors and co-workers think and by what people say on television and on the internet. Getting investor emotions under control is a community project.

    When we all feel comfortable talking about the effect of valuations on long-term returns (which we have "known" about since the academic research on this question was published 28 years ago), The Emotion Problem will go away. When we stop denying our emotions, we will be able to rein them in to the extent needed to permit our intellects to work for us instead of against us.

    The Buy-and-Hold Model insists that valuations (and, thus, emotions) be ignored. Ignoring emotions makes them ten times more powerful. We are living through the most emotional time to invest in stocks that the world has ever seen. The good news is that the financial pain that we have caused ourselves is well on the way to becoming so great that we may be getting close to working up the courage to begin discussing the realities in a frank and real and constructive way. Say a prayer!


  3. I think the title is a bit misleading, but the implications are still fascinating. I think the your most accurate characterization of the index fund study is ""Of course, this study wasn’t using people with a particularly deep knowledge of the way markets work, so even though they were extremely intelligent this doesn’t clearly show that smarts don’t help in investing, only that untrained clever people don’t see clearly in the obscure investing universe." In other words, it is not really that being smart makes you dumb when it comes to investing. It's just that being dumb at investing, will leave you vulnerable to whatever biases you bring to the table. Apparently, smart people have a bias for over-doing it when it comes to creating clever decision-making rules.

  4. Hi Dr. Duru

    Yes, the title's stupid. Wish I'd though of something better.

    You have, I think, put your finger on the pulse of the problem. It looks like the "dumb" participants engaged in a spot of mental accounting, simply spreading investment across the available funds. The "smart" ones seem to have fallen victim to some sort of overconfidence bias.

    Whether this is a facet of the study design or not is hard to determine. It's also not easy to decide whether this is an analogy for (say) index investors ("dumb") and active investors ("smart") - although it's tempting to do so.

    Hopefully there'll be some follow-up research, but I haven't found any yet.

  5. According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds. These tracking error differences are comparable to management fees.

  6. By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs. Thus, a poorly managed fund might have low management fees but poor tracking error and therefore be lower performing. Thus, it is not always the fund with lower fees that yields the highest return.