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Intelligence failure

It's not because investors are stupid. In fact, new research suggests that intelligent investors' fund choices are no better than stupid investors' ones. A team of economists led by Mark Grinblatt at the University of California Los Angeles studied the unit trust holdings of Finnish investors. And they found that while investors with high IQs were more likely to buy funds with low fees, their investments performed no better than those of investors with lower IQs.

This corroborates other research. A study of over 3,000 German investors by economists at the University of Mannheim found that while financially literate investors are more likely than others to own tracker funds, even they also buy active funds. And they do so unwisely. The researchers concluded: "Differences in fund performance are not related to differences in financial literacy. As a group, sophisticated investors do not earn higher risk-adjusted returns with their cash moves into mutual funds."

Knowledge and intelligence, then, seem to be little help to us in spotting good unit trusts.

There's a reason for this. Quite often, as our knowledge and ability increases, our confidence increases even faster, with the result that we become overconfident; we acquire what Nobel laureate Daniel Kahneman calls the "illusion of skill". This causes us to think that we can identify fund managers who can beat the market when in fact we often cannot. Such overconfidence means that even the smart money can make dumb decisions.

Herein, though, lies a paradox. Financial literacy and confidence - even overconfidence - are not always bad things. Annamaria Lusardi of Dartmouth College has shown how financial nouse is strongly associated with better preparedness for retirement and lower personal debt. And we need confidence to steel ourselves to take risky but profitable decisions to own shares, start our own business or change jobs. Knowledge and confidence, then, are often good things; this is why humans have evolved to be overconfident. It's just that - like most good things - they have a price.

*Your correspondent owns both these funds.