Strong evidence exists that stock market participation is driven by intelligence
quotient (IQ) level more than by any other factor. Low-IQ investors earn
inferior risk-adjusted returns, which may be a better explanation for their low
participation than costs alone.
Just half of U.S. households invest in stocks in some form, whereas traditional financial
economic models suggest near-universal participation. This discrepancy describes the
“participation puzzle,” which the authors explore by investigating the
intelligence quotient (IQ) as a primary driver.
Two large provinces around Helsinki form the basis of an expansive dataset. IQ data are
obtained from nearly 160,000 Finnish Armed Forces (FAF) intelligence assessment tests
taken between 1982 and 2000 by males at commencement of their compulsory national
service. IQs are categorized on the stanine scale of one to nine. The Finnish Tax
Administration provides income, wealth, demographic, and address data from year 2000 tax
returns. Household trade data are obtained from the Helsinki Stock Exchange (HEX) for
1995 to 2002, with year 2001 returns used to compute portfolio variance.
Summary statistics show that average stock market participants have higher IQs (by one
stanine), earn 50 percent more income, are more educated, and are more likely to be
married and have children than nonparticipants. Additionally, income, wealth, and the
ratio of those with the highest to those with the lowest educational attainment increase
monotonically with IQ. Participation increases from 10 percent to 47 percent between the
lowest and highest IQ extremes.
The authors study the marginal effect of IQ on participation by introducing 67 control
variables and performing probit regressions. Participation increases monotonically with
IQ, and they observe a statistically significant difference of 20 percentage points
between the extreme stanines. IQ differences represent the greatest explanatory
variable, which are 20–30 percent larger than those explained by income
differences. All three subcomponents of IQ influence participation, with a
measurement year, when the authors omit blocks of control regressions, age-filtered
samples, Nokia holdings, and employer stock holdings.
To exclude any possibility of participation costs driving the IQ–participation
relationship, the authors next restrict the test to include only the most affluent.
Within the top decile of income/wealth, there is a 16–23 percentage point
participation rate difference between the extreme IQ stanines, which is comparable with
the full sample findings.
To assess secondary effects, such as IQ leading to wealth, income, and so on, the authors
use the Blinder, Oaxaca, and Fairlie method. This method shows that secondary effects
account for around 64 percent of the 37 percentage point difference in participation
between the highest and lowest IQ stanines, with wealth, education, and income being the
main conduits.
The FAF data cover males only. Address information, however, allows sisters to be
identified. Using brothers’ IQ as a proxy, the analysis is repeated on more than
4,000 sisters. The authors observe a similar, if less significant,
IQ–participation relationship. The robustness of the technique is verified by
identifying brothers whose IQs are already known. They also find that endogeneity, which
is the possibility of shared family knowledge, is important when using brother
pairs.
After establishing that IQ level is a strong driver of stock market participation, the
authors investigate possible causes. By inference from the HEX data, they find that
low-IQ investors earn statistically significantly lower Sharpe ratios, mainly driven by
higher diversifiable risk levels. A 3.5 percent increase in return variance per
one-stanine drop in IQ is observed. Additionally, high-IQ investors own more stocks and
have more exposure to high book-to-market and small stocks, which are well established
as returning higher Sharpe ratios. For a 30 percent risk portfolio, bottom-stanine IQ
investors earn at least 21–33 bps less annually than top-stanine investors,
justifying the supposition that low-IQ investors rationally opt out of stock market
investing.
The authors conclude that IQ is an important determinant of stock market
participation—and rationally so, given likely return differences. They proffer
that the compounding effect of higher returns may be as important in explaining wealth
differences across IQ levels as is earned income. Finally, the authors hypothesize that
markets may be more efficient than previously assumed because participants are smarter
than average.