Are High IQs Key to Successful Investing?

Yale Professor Robert Shiller thinks so.

Writing at the New York Times,

YOU don’t have to be a genius to pick good investments. But does having a high I.Q. score help?

The answer, according to a paper published in the December issue of The Journal of Finance, is a qualified yes.

The study is certainly provocative. Even after taking into account factors like income and education, the authors concluded that people with relatively high I.Q.’s typically diversify their investment portfolios more than those with lower scores and invest more heavily in the stock market. They also tend to favor small-capitalization stocks, which have historically beaten the broader market, as well as companies with high book values relative to their share prices.

The results are that people with high I.Q.’s build portfolios with better risk-return profiles than their lower-scoring peers.

Certainly, caution is needed here. I.Q. tests are controversial as to what they measure, and factors like income, quality of education, and family background may not be completely controlled for. But the study’s results are worth pondering for their possible implications.

So how valid is such claim?

Let’s get some clues from some of my favorite investors.

Here is the legendary Jesse Livermore (bold emphasis mine)

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight. Old Turkey was dead right in doing and saying what he did. He had not only the courage of his convictions but also the intelligence and patience to sit tight.

When I am long of stocks it is because my reading of conditions has made me bullish. But you find many people, reputed to be intelligent, who are bullish because they have stocks. I do not allow my possessions – or my prepossessions either – to do any thinking for me. That is why I repeat that I never argue with the tape.

Mr. Livermore simply posits that intelligence can be overwhelmed by egos and cognitive biases (particularly in the second quote the endowment effect, Wikipedia.org—where people place a higher value on objects they own than objects that they do not.).

Here is the 10 investing principles by another investing titan the late Sir John Templeton

1. Invest for real returns 2. Keep an open mind 3. Never follow the crowd 4. Everything changes 5. Avoid the popular 6. Learn from your mistakes 7. Buy during times of pessimism 8. Search worldwide 9. Hunt for value and bargains 10. No-one knows everything

More from John Templeton

“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Here is value investor turned crony, Warren Buffett. I’d say that Mr. Buffett’s original wisdom has been a treasure. (bold emphasis mine)

‘I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.’

‘Read Ben Graham and Phil Fisher read annual reports, but don’t do equations with Greek letters in them.’

‘Never invest in a business you cannot understand.’

‘You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.’

Does all the above sound like high IQ stuff? Evidently they represent more common sense and the school of hard knocks stuff.

Yet to the contrary, high IQs can translate to portfolio disasters.

The landmark bankruptcy by Long Term Capital Management in 1998 had been a company headed by 2 Nobel Prize winners. The company’s failure has substantially been due to flawed trading models.

In 2008, the 5 largest US investment banks vanished. These companies had an army of economists, statisticians and quant modelers, accountants, lawyers and all sort of experts who we assume, because of their stratospheric salaries and perquisites, had high IQs.

When Queen Elizabeth asked why ‘no one foresaw’ the crisis coming, the reply by the London School of Economics (LSE)

"In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."

Imagination had been scarce because the same army of experts heavily relied on mathematical models in dealing with investments. They did not follow the common sense advise by the real experts.

My favorite iconoclast author Nassim Taleb in Fooled by Randomness offers an explanation (emphasis added)

it is also scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.

What the consensus mistakenly thinks as rational is, in reality, the emotional. Thus, we need more Emotional Intelligence (EI) rather than high IQs

The most important observation or lesson is one of the repeated botched attempts by high IQ people to transform investing into ‘science’.

Well, because investing involves people’s valuations and preferences, all of which constitutes human action, in truth, investing is more than science…

As the great Ludwig von Mises explained. (bold highlights mine)

For the science of human action, the valuations and goals of the final order at which men aim constitute the ultimate given, which it is unable to explain any further. Science can record and classify values, but it can no more "explain" them than it can prescribe the values that are to be acknowledged as correct or condemned as perverted. The intuitive apprehension of values by means of understanding is still not an "explanation." All that it attempts to do is to see and determine what the values in a given case are, and nothing more. Where the historian tries to go beyond this, he becomes an apologist or a judge, an agitator or a politician. He leaves the sphere of reflective, inquiring, theoretical science and himself enters the arena of human action.

...but rather, investing is an art.

Again Professor Mises from the same article.(emphasis added)

The position of science toward the other values of acting men is no different from that which it adopts toward aesthetic values. Here too science can do no more with respect to the values themselves than to record them and, at most, classify them as well. All that it can accomplish with the aid of "conception" relates to the means that are to lead to the realization of values, in short, to the rational behavior of men aiming at ends.

Bottom line: The art of managing our emotions or emotional intelligence, via common sense and self-discipline, is more important than having high IQs.