Sunday, January 10, 2010

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.


Anonymous said...

Hmmm - where does it leave the LTCM crowd?

Unknown said...

You basically already said this, but: None of this means that it's possible to make a living picking up $100 bills. But it is still possible to make a living DROPPING $100 bills.

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Plamen said...

Eric, if your money is parked in a variable annuity with a certain company, you can trade daily with NO (as in ZERO) marginal transaction costs. I will not venture any more in an open forum, since this is partly how my employer makes money, but under those circumstances, if you net an advantage of 1 basis point per trade (trading every business day), it adds up to 2.53% per year. Yes, the annuity costs will eat up some of that edge, but 1 bp is a somewhat arbitrary and conservative estimate too, I am sure you'd agree. I agree alpha is hard to find, but if you have found it, there are ways to exploit it. Happy to tell you more in 1-on-1 talk - not that I think it'd be interesting to you, but just in case you suspect I am making pie-in-the-sky assertions.

N N said...

"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"

This is incorrect. Scores of traders/day-traders make money with no informational edge outside what is freely available. There are sources of alpha yet undiscovered by academia.

Eric Falkenstein said...

Plamen: trading costs consist of commissions, bid-ask spread (aka vwap miss), and price impact. I think you're only focusing on commissions.

NN: while some do make money, on average pnl is highly negative for short term traders. I'm talking about an average, not some.

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