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Monday 28 November 2011

Are You A Born Investor?

Your Stocks in Your Genes

One of the many problems that have perplexed economists, along with why more people aren't like them and why no one listens to them any more, is why more people don’t participate in the stock market when it's regularly feted as being the safest place to put your money, long-term: the so-called equity premium model (for more of which see Mental Accounting: Not All Money Is Equal). Of course this isn’t necessarily true, as it’s been shown that it's another myth of the market, but given the amount of money spent on promoting the idea of stocks as bound to outperform, it’s as good as, and you might expect people to invest accordingly.

One line of thought suggests that the participation puzzle of why more people don't invest in stocks may be explained by genetic differences in brain function. As usual, IQ is a suspect, but the evidence suggests most investors are as dumb as everyone else, especially IQ researchers, and we should look instead at an old friend: emotions. It may be that some of us are just born investors.


The idea that genes determine behaviour has been around for ... well, for about as long as the idea of a gene has been around. The problem is how to separate the effects of nature and nurture on behaviour, because the impact of upbringing on our conduct is known to be profound. Teasing apart environmental and genetically determined behaviours is, fundamentally, damn difficult despite the reams of material written to suggest otherwise: it's like trying to unbake a cake.

Historically psychologists have had a single, powerful, tool available to analyse these types of problems: the twin study, using the differences between identical twins and fraternal twins to discern effects which are mainly genetically derived. The trick is that all non-separated twins will have a similar upbringing but identical twins are genetically identical while fraternal twins are only genetically similar: so differences are likely  to be down to genetics, not environment..

So a simple twin study will look at whether identical twins are more similar on a certain trait than fraternal twins and then assume that any statistically significant difference has a genetic basis. That this isn't necessarily a safe assumption is drawn out in this paper by Peter Schonemann, which points out that a lot of the models in this area aren't entirely sound: for instance, in one case a twin study suggests that religious preference is more heritable than race – leading to the odd conclusion that you're more likely to change your parentage than your faith.

Stockmarket Twinning

Nonetheless, twin studies are one of the best ways we have of trying to detect genetic influences and have helped identify a wide range of areas in which nature is a significant factor in behaviour. The question here is whether stockmarket participation is one of them?

Roughly the answer appears to be yes. When Barnea, Cronqvist and Siegel looked at the investment behaviour of identical and fraternal twins gleaned from public records in Sweden they found that:
“About a third of the cross-sectional variation in stock market participation and asset allocation decisions across individuals is explained by a genetic factor. We also demonstrate that the genetic component does not disappear with age, is significant even among twins who do not interact frequently, and accounts for a significant proportion of the variance also among pairs of twins who were reared apart”.
This isn’t just significant in a statistical sense, but in the more normally accepted use of the word as well: most other suggested characteristics have far lower impacts on asset allocation. However, just knowing that there’s a significant genetic component in stock market participation is really only half the story because we can be pretty sure that there’s no gene that directly causes people to go out and start risking their capital on stocks. So what is the genetic mechanism?


As usual, when we start looking at genetic models, the idea of IQ appears. As we’ve discussed before, and Schonemann brings out in the paper quoted above, it can be quite hard to determine what IQ is actually testing, other than the researchers' own prejudices. For example, most measures of human intelligence imply that it's more heritable than the length of wool produced by sheep. As the difference is that ovine experimenters can actually create controlled experiments, which have some hope of accuracy, whereas researchers on humans can only use the data that's naturally available, a reasonable guess might be that the latter are making some rather overoptimistic modelling assumptions in drawing their conclusions: it beggars belief that "intelligence" is the most heritable characteristic ever measured. Whatever it is.

Still, if we give this research the benefit of the doubt it's widely believed that human IQ has a genetic component. As it’s also frequently, if rather inaccurately, measured it therefore provides an attractive data set for researchers looking for something interesting to publish.

Unsurprisingly, then, we can find some research on IQ and Stock Market Participation which shows that stock market participation is predicted by IQ tests; well, at least those taken by young Finnish males. Moreover, they show that participation is not particularly impacted by wealth – richer participants with lower IQs were just as unlikely to invest in stocks as poorer ones, so this doesn’t appear to be a funding related problem. In fact the general conclusion is:
“High-IQ participants are more likely to hold mutual funds, larger numbers of stocks, and have lower-beta portfolios than lower-IQ participants. High-IQ investors also have greater exposure to the risks of small and value stocks. These results lend credence to the story that high-IQ subjects participate because they face a superior risk-return trade-off and that low-IQ subjects shun participation because they make investment mistakes.”
In fact the range of results from this study are really quite interesting. For instance:
“High-IQ investors are more likely to have larger Sharpe ratios because of increased diversification (from holding mutual funds and greater numbers of stocks). They also prefer Sharpe ratio enhancing factor exposures (from low beta, high book-to-market, and small stocks).”
In other words, smarter investors are heavily diversified and value focussed.

Cognitive or Emotional?

Of course, the idea behind this is that IQ is somehow, by some unspecified means, related to cognitive capability which is itself genetically determined to some extent. However, cognitive processing abilities don’t necessarily explain all aspects of behaviour; as we saw in Gambling, From Iowa to Soochow, emotional reactions are bound up in cognitive processing, often as short-cuts to reduce the amount of brainpower needed to make everyday decisions.

Another set of researchers has looked at whether the brain’s serotonin system – a mechanism for transporting the neurotransmitter in question – may influence investment behaviour. Serotonin is implicated in triggering areas of the brain that generate negative or positive emotional reactions – e.g. anxiety or excitement – when risk taking is anticipated. It's a useful proxy for genetic involvement in associated behaviors because there are two gene variants for the system which transports serotonin around the brain, one of which causes increased anxiety and decreased anticipation in risky situations.

Serotonin Triumphs

Kuhnen, Samanez-Larkin and Knutson examined whether the different serotonin transporter genes – alleles – predict different financial behaviour:
“Brain imaging data suggests that, relative to individuals carrying the long version of the gene, those carrying the short version experience higher anxiety when faced with investments where losses are possible, and lower excitement when gains are likely.”
Interestingly the researchers find that this behaviour is independent of cognitive abilities – i.e. the thing that IQ is supposed to test for. Nor are the effects related to education or learning abilities. It just appears to be an emotionally driven behaviour, albeit one that’s genetically mediated:
“The gene effect seems to be related to psychological, emotion-driven differences between those carrying the short and the long alleles. Short allele carriers have higher scores on neuroticism and negative affect, and lower scores on positive affect, suggesting that these individuals are ex-ante focused on the negative potential outcomes of their financial choices, and as a result, choose to avoid complex and risky financial investments.”
Who's Irrational Now?

There is one peculiar impact of this research, if it turns out to be correct, which is that the people who invest in stock markets are more rational, in the economist’s meaning of the term, than those that don’t. Which also means that those behavioural studies that examine random selections of people outside of the markets probably don’t transfer over directly, because people in the markets are a self-selecting, non-random group. Which is a participation puzzle to be sure, but just of a different kind than the one that the researchers were looking for.

However, as research on stock market investors reveals anyway that we are, as a bunch, profoundly irrational this does raise one worrying point. That if we investors are the smart ones then the rest of the population must be one hell of a fearful mess.

Related articles: The Neuroeconomics RevolutionStocks Aren't Snakes, Get An Emotional Margin of Safety, What's Your Financial IQ?


  1. I suspect the biggest effect is barrier to entry. I'm involved in the industry, have a SIPP and a broker account and yet the thought of starting a new one fills me with apprehension.

    Even if you know what you're doing, the endless variety of tradables, differing raters, etc makes for a scary proposition.

  2. In my opinion, an emotional person can not invest wisely and can not get success in that. Investment requires a wise approach not just fluctuating and flexible every time as emotions.