Sunday, June 15, 2014

Financial Understanding and Investment Performance: No Monkey Business?

Knowledge is Good. 

From The Economist's Free Exchange blog:

 
“A BLINDFOLDED monkey throwing darts at a newspaper’s financial pages,” wrote Burton Malkiel in “A Random Walk Down Wall Street”, his 1973 bestseller, “could select a portfolio that would do just as well as one carefully selected by experts”. Many investors took issue with Mr Malkiel, an economics professor at Princeton University. Some researchers have also contested his prediction, but not because they think that he exaggerated the power of randomly picking stocks; rather that he was too modest. Simulating a dart-throwing monkey has resulted in portfolios that would not just beat many investors, but also outperform the market.

In a study Robert Arnott and his co-authors picked 100 portfolios, each with 30 equally-weighted stocks from the 1,000 largest American stocks by market capitalisation. 94 of the 100 “dartboard portfolios” did better than a market cap-weighted portfolio of all the 1,000 stocks. Similarly, in another study Andrew Clare, Nick Motson and Steve Thomas randomly picked American stocks to construct ten million indices. An additional twist to their experiment was that the stocks were also randomly weighted. Nearly all of the ten million "monkey indices” delivered “vastly superior returns” compared to a cap-weighted index.

Since less-developed primates appear to be better at picking stocks than experts, one may be tempted to infer that less-skilled humans would make better investors than those with high financial literacy. Not so. At least not according to a new paper by Robert Clark, Annamaria Lusardi and Olivia Mitchell, which finds that individuals who are more financially knowledgeable earn greater returns on their retirement plan investments.
The authors used data from a large American financial institution that offers its employees 401(k) plans, a defined contribution retirement plan, that include choices of stock and bond indices, emerging market funds and a real estate fund. The study linked each employee’s contribution rates and investment allocations to data on returns over a period of ten years. To estimate the relationship between the employees’ returns on their retirement plan investments and their financial knowledge, the researchers fielded an internet survey by email. Among other questions, respondents were asked if they would have more than $110, exactly $110 or less than $110 after depositing $100 for five years in a savings account with a constant annual interest rate of 2%.

Mr Clark and his co-authors found that while employees who score higher on the survey have more volatile portfolios, they do no better at diversification. Nonetheless, expected risk-adjusted annual returns are 130 basis points higher for the most financially literate individuals compared with their least knowledgeable peers. The authors therefore conclude that “financial knowledge does appear to help people invest more profitably” and that this may be a reason to “enhance financial knowledge in the population at large”....MORE
And everyone will be above average.
Possibly also of interest:
What Monkey Pornography and Celebrity Worship Tells Us About Human Nature 
Commodity traders superior to chimpanzees, research shows
Jim Cramer beats Monkey in Stock Picking Contest!
UPDATE-Jim Cramer Beats Monkey in Stock Picking Contest
What Jim Cramer Does After Beating the Monkey