Understanding the Correlation Between Intellect and Investment Performance

Is that brainiac sitting in the corner really going to emerge as the top investor? Do intuition and an innate “business sense” play a role in the success of investment?

     Apparently not - in their 2008 article entitled “Intelligence and Trading Performance,” Mark Grinblatt of UCLA, Matti Keloharju of the Helsinki School of Economics, and Juhani Linnainmaa of the University of Chicago find that overall intellect trumps innate business acumen in determining investor behavior and performance. 

     With that in mind, higher-scoring participants averaged an annualized return 16.3 percent higher than that of lower-scoring participants. A possible reason for this discrepancy is that the latter group investors were more prone to mistakes, such as the placement of limit orders without expiration and un-hedged exposure to market shocks. Although mistakes may account for a portion of the difference, the majority of the differential is explained by the fact that smarter investors interpret market signals, and thus choose to purchase stocks differently.

     Differing reactions to market signals aren’t the whole story, however. To better analyze the trends, Grinblatt et. al. broke down the average daily returns into several time categories indicating how long the investor held the stock. Over one- or two-day intervals, more intelligent traders earned a significantly higher return than the rest at 0.06% versus 0.01%, and continued to do so even when the period was extended to sixty days. This implies that more intelligent investors can pick good stocks not only around the time of earnings announcements, when stocks move aggressively and nearly anyone can make money, but also when market signals are less obvious. This finding ruled out the possibility of access to higher-quality information for more intelligent investors, although differing information over time remains a possibility.

     In addition to casting some doubt on the efficient markets hypothesis, the research could provide insights to governments deciding whether to sponsor financial information classes for their citizens. Even after controlling for financial experience, investors who scored below average on their intelligence tests did not produce returns equivalent to what their higher-scoring peers did. Perhaps, remark Grinblatt et. al., governments should discourage investment from less intelligent subjects or increase regulation in order to prevent them from losing their own money.