Your correspondent recently looked again at the econometrics textbooks he used at university. And he didn’t understand a thing, despite getting good marks in the subject. One lesson of this could be that exams are a bad measure of ability. But there’s another one. This corroborates what psychologists have long said – that most aspects of our fluid intelligence decline from early adulthood onwards.
This poses a big question for investors: do we need to be intelligent?
Warren Buffet thinks not. “Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ,” he has said.
If he’s right, it’s good news for those of us with ageing brains.
Sadly, however, it might not be right. Evidence here comes from Finland. It still has national service, and while there’s much to be said against conscription it has the great merit of generating lots of data. Every young Finn who is conscripted takes an IQ test. The UCLA’s Mark Grinblatt and colleagues correlated these test scores with investors’ performance years later. And they found that the most intelligent 4 per cent of men earned equity returns which were almost five percentage points better per year than men of below-average intelligence. What’s more – and contrary to Mr Buffett’s claim – the most intelligent men did better than those of high but slightly lesser IQ.
This fits with some US evidence. “Investment skill deteriorates with age,” George Korniotis and Alok Kumar at the University of Miami have concluded. They show that while older investors are more likely to follow good rules of thumb, their stockpicking skill worsens as they age.
Which poses the question: why does intelligence improve investment performance?
One possibility is simply that it enables investors to convert knowledge about companies into better stock picks.
This theory, however, runs into two awkward facts. One is that as the LSE’s Christopher Polk and colleagues have shown, the typical fund manager has only a handful of decent stock ideas. This poses the question: why, then, should an intelligent amateur do better than an intelligent professional?
The other awkward fact is that investment performance is streaky. Even years of good performance can suddenly lead to bad, as investors in Neil Woodford’s funds know. This happens without investors suffering a sudden loss of IQ.
These two facts suggest another reason why intelligence might work. It’s that, as Professor Grinblatt says, intelligent investors have a “greater immunity to behavioural biases”. They are less likely to sell winning stocks and hold on to losers, so they don’t bet against momentum. They also incur lower dealing charges, he shows, and are less likely to buy at the top of the market.
Intelligence does not, however, wholly protect us from mistakes. Other work by Professor Grinblatt has found that intelligent investors are as likely as stupider ones to buy unit trusts with good recent short-term performance, even though that performance is no guide to future returns.
Worse still, intelligence can actually lead us into error by making us overconfident. Sebastian Muller and Martin Weber at the University of Mannheim show that even the most financially literate investors buy lots of expensive and poorly performing unit trusts. This, they say, is because financial acumen encourages us to believe that we have the ability to spot good fund managers. This can be an expensive mistake. If you hold a fund that performs in line with the market but charges 0.75 per cent a year more than a tracker, then you will lose over £1,000 on every £10,000 over a 10-year period.
Charlie Munger, Mr Buffett’s colleague at Berkshire Hathaway, says it is vital that investors know the edge of their competence – that they know what they don’t know. Because intelligent people overestimate the importance of intelligence (which is a form of that well-known error, the endowment effect) they fail to see this. History (and for that matter the present day) is littered with highly intelligent men making fools of themselves by stepping beyond the edge of their competence. William Shockley and Bobby Fischer are two examples, but you all know more. In the same way, I suspect, lots of high-IQ men piled into tech stocks in 2000 and Bitcoin at its 2017 peak.
Herein lies hope for those of us whose fluid intelligence is on the wane. We might not be intelligent, but we can at least be wise. What we lose in fluid intelligence, we gain in crystallised intelligence.
Sticking to a handful of rules can save us money: prefer trackers to expensive actively managed finds; minimise dealing costs and taxes; be wary when a price falls below its 10-month average; use the dividend yield on the All-Share index as a guide to long-term returns; be aware of what you don’t know; and avoid the well-known mistakes of trading too much, overconfidence and holding on to losing stocks.
Obeying these rules won’t maximise your wealth, but they probably will protect you from the worst losses. And you don’t need much intelligence to follow them: what you need instead, as Mr Buffet has said, is emotional stability.
Maybe we do need intelligence to beat the market. But we don’t need it to avoid underperforming it. In this sense, investors don’t need to be very smart. Which for some of us is great news.
