Blogs | December 3, 2018

Here’s how to get rich investing. Or not

Investors need a wealth of knowledge and dearth of overconfidence, notes Chris Dillow

What makes us rich? Parents and governments may tell us it is all about working hard and doing well at school. New economic research this year, however, shows this isn’t the whole story.

For one thing, our genes matter. Daniel Barth, Nicholas Papageorge and Kevin Thom, three US researchers, have found that genetic endowments related to educational attainment “strongly predict” people’s wealth at retirement.

This isn’t because these genes determine how educated we’ll become and whether we get a good job or not. Even controlling for qualifications and income, as well as inheritances, they still affect how wealthy we become. This suggests that genes influence how well we save and invest.

Smarter investing
This is not simply because more intelligent people make better investment decisions. As Warren Buffett has said, “investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ".

Instead, it’s likely that self-discipline is the key. This can help us to save more and invest. And if we do so from an early age, the power of compounding can make us rich. Other new research shows that something else also helps make us rich: knowing our limits.

Su Hyun Shin of the University of Alabama and Andrew Hanks of Ohio State University studied thousands of Americans aged over 50 and found that those who were overconfident about their thinking and memory skills had significantly less net wealth than others. This holds true even controlling for obvious causes of such differences such as age, education, health and income.

“Overconfidence has a negative impact on net worth,” says Shin. One reason for this is that if we are overconfident we’ll save less or borrow more in the expectation of getting a well-paid job in future that never actually materialises.

Wasted activity
Also, overconfident investors waste money on dealing charges and fund management fees because they wrongly believe they can spot good stocks and clever fund managers. Expensive as it is, overconfidence is difficult to avoid. Other new research this year has shown how easy it is to become overconfident.

One way this can happen is that we are too quick to draw inferences from noisy data. An experiment by Victor Haghani and colleagues at investment managers Elm Partners has shown this. They asked 700 people: "If you had two coins, one fair and one with a 60% chance of turning up heads, how many tosses would you need to be 95% confident of identifying which coin was biased?”

"Those who were overconfident about their thinking and memory skills had significantly less net wealth."

The typical answer was 40. The correct answer is in fact 143. That’s because there’s a good chance of the biased coin coming up tails a lot, and because 95% confidence is a high bar. Picking good funds is much like this. We need to see many years of returns before we can infer whether a fund manager is skilful or just lucky.

Haghani says: “Five to ten years of track record just doesn’t tell us that much.”

Can you trust it?
A second pathway to overconfidence is that we can trust even good advice too much. Economists at the University of Maryland show how this can happen. They looked at what happened when a stockbroker used portfolio optimisation software to give clients share recommendations.

Many clients benefited from this advice. But some lost.

Sophisticated investors who used it traded more often to no useful effect, thereby incurring excessive dealing costs. Good advice gave them the illusion of knowledge and a certainty which did not exist.

A third way to become overconfident is to rely on knowledge that is in fact out of date. This is a special danger in stock markets: investors should wise up. If they see that some types of share do well on average, and buy those shares, they can bid up their prices to levels from which subsequent performance is only average.

Ruling Britannia
John Cotter and Niall McGeever at University College Dublin show that this has happened in the UK. They show that several UK stock market anomalies have weakened since the 1990s, such as the tendency for companies with high accruals or for growth stocks to underperform.

This corroborates a US market finding by Jeffrey Pontiff at Boston College and David McLean at Georgetown University. It’s easy for investors to lose money therefore by having too much confidence in evidence that no longer holds true.

All the research I’ve cited here was published in the last 12 months, although in many cases it adds to earlier findings. This perhaps is the main point: If you look only at mass media you’ll get a distorted perception of what economics is – as if it were about forecasts for economic growth and advice for governments and policymakers.

In fact, economics is much more than that. It is a science which progresses – albeit slowly – and which can help us all in our everyday decision-making.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist