IQ and Trading Profits

A paper by Mark Grinblatt and two Finnish guys whose names I can't pronounce (Linnainmaa & Keloharju), took data from Finnish military IQ tests, and combined them with transactional data on the Helsinki Stock Exchange. The paper is cleanly titled, "Do Smart Investors Outperform Dumb Investors?"

From the abstract:

This study analyzes whether high IQ investors exhibit superior investment performance. It combines equity return, trade, and limit order book data with two decades of scores from an intelligence test administered to nearly every Finnish male of draft age. Controlling for wealth, trading frequency, age, and determinants of the cross-section of stock returns on each day, we find that high IQ investors exhibit superior stock-picking skills, particularly for purchases, which earn up to 11% more per year than the purchases of below average IQ nvestors.

Wouldn't it be interesting if, instead of expected returns being a function of an asset's risk, it was a function of the investor's smarts? It seems plausible, indeed, I argued in my book that alpha is not really a function of an asset, but rather, of the investor. Gold, day-trading, futures, are not really attractive in themselves, but rather if they are consistent with your relative skills.

They group investors into a stanine distribution, where 1 is low, 9 is highest. The highest IQ group has a 4.4 basis point return advantage, looking at their picks on day t-2, and return on day t. This annualizes to 11% (252*.00044), but that isn't very realistic, because you can't trade that much. The advantage peters out, as after two months the return advantage is only 0.5 basis points.

The paper notes a distinct short run advantage to high IQ traders. This seems to make sense, but one should remember investing is not a sprint, but a marathon. Grinblatt and company show higher IQ investors are more diversified, and trade less, than their stupid counterparts, so it does seem like those who trade benefit from smarts.

I think this is a lot like noting that smarter gamblers are better gamblers, because everyone in this paper is trading all the time, for edges of basis points, when the transaction cost merely on the bid-ask is 100 basis points. The really really smart (wise?) people do not gamble at all, because they know the long-run house edge kills any edge they might have. In trading, trying to make money with trade horizons less than a year, the only way to make consistent money is to be an insider, why brokers have nice yachts ('where are the customer's yachts?'). The best stock strateg is something very passive, because a 4 basis point edge does not overcome transaction costs, whereas a simple strategy of buying, say, low volatility portfolios generate a superior Sharpe ratio and is very feasible.