Blogs | March 26, 2013

Don’t put off saving because you think you need to be clever. You don’t.

Finance and investment are complicated, so you need lots of brainpower to do well. The financial services industry does little to dispel this belief. But it is wrong.


The Finnish military requires almost all young men to serve for a few months. New recruits are given an IQ test. And a team of researchers led by Mark Grinblatt of the University of California Los Angeles compared those IQ scores to the investment performance of those men in the later life. What they learned: the "smarter" ones don't necessarily pick the best investments.

Intelligence doesn’t help us pick good funds
For investments in mutual funds, they found that high-IQ investors funds do not earn significantly greater net-of-fee returns or risk-adjusted returns than low-IQ investors’ funds.  In other words, intelligence doesn’t help us pick good funds. Much the same is true for shares. They also found that, after a month, the shares bought by more intelligent investors did no better than those bought by less intelligent ones.

This is no mere quirk of the Finnish character. The same thing is true in Germany. Economists at the University of Mannheim tested investors’ knowledge of finance and compared it to the performance of the mutual funds they bought. Their result? “The level of financial literacy is not related to the performance of the actively managed funds that our participants selected.”

But intelligence does help avoid mistakes
This doesn’t mean intelligence is useless. Intelligent investors do a lot right, says lead researcher in the Finnish study Grinblatt. They are more likely to invest in tracker funds and in lower-cost mutual funds. They are better at timing their share purchases; it was, he says, the less intelligent investors who tended to enter the stock market nearer the peak of the tech bubble in 1999.

They are better at minimising their tax bills, for example by selling losing stocks to reduce capital gains tax liabilities. And they are less likely to hold onto bad stocks in the hope of them returning to the price at which they bought them; they are less prone to the disposition effect.

Intelligence and brains, then, are good for us not because they help us to pick the best investments, but because they help us avoid some of the worst mistakes we can make.

But why are brains so little use in spotting good shares or funds? One reason is that conventional economics is actually correct in one important respect. Markets are informationally efficient, in the sense that available public information is already embedded in prices. If everything is in the price, then there’s nothing useful that even the best brains can learn.

Beware the “illusion of skill”
However, it’s possible that brains can actually be harmful. Intelligence and financial literacy can give us what the Nobel laureate Daniel Kahneman has called the "illusion of skill". Smart people become overconfident, and think they know more than they do and so can buy bad funds. As Will Rogers said: “It isn't what we don't know that gives us trouble, it's what we know that ain't so.”

All this suggests you should not be put off from saving by the belief that you need to be clever. You don’t. It doesn’t take much intelligence to buy an equity tracker fund.

Smart thinking about the future
Perhaps, though, financial knowhow matters in a different way. Annamaria Lusardi at Dartmouth College points out that financial literacy is strongly correlated with better preparedness for retirement.

Why might this be? An experiment by Shane Frederick at the Massachusetts Institute of Technology shows how. Answer the following question: “A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost?” The snap answer is 10 cents. But, if you think about it a little, you’ll see this is wrong and that the answer is five cents.

Professor Frederick found that people who gave the incorrect, snap answer to questions such as these tended to be more impatient than those who gave the right answer when asked to choose between a reward now and a bigger reward later. This suggests that an ability to think and reflect before answering is associated with time preference, the willingness to delay gratification.

Perhaps, then, brains are good for savers not because they help us make the right investment choices, but because they help us to save in the first place.

InvestingEconomicsRiskFunds

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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