Monday, 28 November 2011
Your Stocks in Your Genes
One of the many problems that have perplexed economists, along with why
more people aren't like them and why no one listens to them any more, is
why more people don’t participate in the stock market when it's
regularly feted as being the safest place to put your money, long-term:
the so-called equity premium model (for more of which see
Mental Accounting: Not All Money Is Equal). Of course this isn’t necessarily true, as it’s been shown that it's
another myth of the market,
but given the amount of money spent on promoting the idea of stocks as
bound to outperform, it’s as good as, and you might expect people to
invest accordingly.
One line of thought suggests that the
participation puzzle of why
more people don't invest in stocks may be explained by genetic
differences in brain function. As usual, IQ is a suspect, but the
evidence suggests most investors are as dumb as everyone else,
especially IQ researchers, and we should look instead at an old friend:
emotions. It may be that some of us are just born investors.
Twins
The idea that genes determine behaviour has been around for ... well,
for about as long as the idea of a gene has been around. The problem is
how to separate the effects of nature and nurture on behaviour, because
the impact of upbringing on our conduct is known to be profound.
Teasing apart environmental and genetically determined behaviours is,
fundamentally, damn difficult despite the reams of material written to
suggest otherwise: it's like trying to unbake a cake.
Historically psychologists have had a single, powerful, tool available
to analyse these types of problems: the twin study, using the
differences between identical twins and fraternal twins to discern
effects which are mainly genetically derived. The trick is that all
non-separated twins will have a similar upbringing but identical twins
are genetically identical while fraternal twins are only genetically
similar: so differences are likely to be down to genetics, not
environment..
So a simple twin study will look at whether identical twins are more
similar on a certain trait than fraternal twins and then assume that any
statistically significant difference has a genetic basis. That this
isn't necessarily a safe assumption is drawn out in
this paper
by Peter Schonemann, which points out that a lot of the models in this
area aren't entirely sound: for instance, in one case a twin study
suggests that religious preference is more heritable than race –
leading to the odd conclusion that you're more likely to change your
parentage than your faith.
Stockmarket Twinning
Nonetheless, twin studies are one of the best ways we have of trying to
detect genetic influences and have helped identify a wide range of areas
in which nature
is a significant factor in behaviour. The question here is whether stockmarket participation is one of them?
Roughly the answer appears to be yes. When
Barnea, Cronqvist and Siegel looked at the investment behaviour of identical and fraternal twins gleaned from public records in Sweden they found that:
“About a third of the cross-sectional variation in stock
market participation and asset allocation decisions across individuals
is explained by a genetic factor. We also demonstrate that the genetic
component does not disappear with age, is significant even among twins
who do not interact frequently, and accounts for a significant
proportion of the variance also among pairs of twins who were reared
apart”.
This isn’t just significant in a statistical sense,
but in the more normally accepted use of the word as well: most other
suggested characteristics have far lower impacts on asset allocation.
However, just knowing that there’s a significant genetic component in
stock market participation is really only half the story because we can
be pretty sure that there’s no gene that directly causes people to go
out and start risking their capital on stocks. So what is the genetic
mechanism?
IQcky
As usual, when we start looking at genetic models, the idea of IQ
appears. As we’ve discussed before, and Schonemann brings out in the
paper quoted above, it can be quite hard to determine what IQ is
actually testing, other than the researchers' own prejudices. For
example, most measures of human intelligence imply that it's more
heritable than the length of wool produced by sheep. As the difference
is that ovine experimenters can actually create controlled experiments,
which have some hope of accuracy, whereas researchers on humans can only
use the data that's naturally available, a reasonable guess might be
that the latter are making some rather overoptimistic modelling
assumptions in drawing their conclusions: it beggars belief that
"intelligence" is the most heritable characteristic ever measured.
Whatever it is.
Still, if we give this research the benefit of the doubt it's widely
believed that human IQ has a genetic component. As it’s also
frequently, if rather inaccurately, measured it therefore provides an
attractive data set for researchers looking for something interesting to
publish.
Unsurprisingly, then, we can find some research on
IQ and Stock Market Participation which
shows that stock market participation is predicted by IQ tests; well,
at least those taken by young Finnish males. Moreover, they show that
participation is not particularly impacted by wealth – richer
participants with lower IQs were just as unlikely to invest in stocks as
poorer ones, so this doesn’t appear to be a funding related problem.
In fact the general conclusion is:
“High-IQ participants are more likely to hold mutual funds,
larger numbers of stocks, and have lower-beta portfolios than lower-IQ
participants. High-IQ investors also have greater exposure to the risks
of small and value stocks. These results lend credence to the story that
high-IQ subjects participate because they face a superior risk-return
trade-off and that low-IQ subjects shun participation because they make
investment mistakes.”
In fact the range of results from this study are really quite interesting. For instance:
“High-IQ investors are more likely to have larger Sharpe
ratios because of increased diversification (from holding mutual funds
and greater numbers of stocks). They also prefer Sharpe ratio enhancing
factor exposures (from low beta, high book-to-market, and small
stocks).”
In other words, smarter investors are heavily diversified and value focussed.
Cognitive or Emotional?
Of course, the idea behind this is that IQ is somehow, by some
unspecified means, related to cognitive capability which is itself
genetically determined to some extent. However, cognitive processing
abilities don’t necessarily explain all aspects of behaviour; as we saw
in
Gambling, From Iowa to Soochow,
emotional reactions are bound up in cognitive processing, often as
short-cuts to reduce the amount of brainpower needed to make everyday
decisions.
Another set of researchers has looked at whether the brain’s serotonin
system – a mechanism for transporting the neurotransmitter in question –
may influence investment behaviour. Serotonin is implicated in
triggering areas of the brain that generate negative or positive
emotional reactions – e.g. anxiety or excitement – when risk taking is
anticipated. It's a useful proxy for genetic involvement in associated
behaviors because there are two gene variants for the system which
transports serotonin around the brain, one of which causes increased
anxiety and decreased anticipation in risky situations.
Serotonin Triumphs
Kuhnen, Samanez-Larkin and Knutson examined whether the different serotonin transporter genes – alleles – predict different financial behaviour:
“Brain imaging data suggests that, relative to individuals
carrying the long version of the gene, those carrying the short version
experience higher anxiety when faced with investments where losses are
possible, and lower excitement when gains are likely.”
Interestingly
the researchers find that this behaviour is independent of cognitive
abilities – i.e. the thing that IQ is supposed to test for. Nor are the
effects related to education or learning abilities. It just appears to
be an emotionally driven behaviour, albeit one that’s genetically
mediated:
“The gene effect seems to be related to psychological,
emotion-driven differences between those carrying the short and the long
alleles. Short allele carriers have higher scores on neuroticism and
negative affect, and lower scores on positive affect, suggesting that
these individuals are ex-ante focused on the negative potential outcomes
of their financial choices, and as a result, choose to avoid complex
and risky financial investments.”
Who's Irrational Now?
There is one peculiar impact of this research, if it turns out to be
correct, which is that the people who invest in stock markets are more
rational, in the economist’s meaning of the term, than those that don’t.
Which also means that those behavioural studies that examine random
selections of people outside of the markets probably don’t transfer over
directly, because people in the markets are a self-selecting,
non-random group. Which is a participation puzzle to be sure, but just
of a different kind than the one that the researchers were looking for.
However, as research on stock market investors reveals anyway that we
are, as a bunch, profoundly irrational this does raise one worrying
point. That if we investors are the smart ones then the rest of the
population must be one hell of a fearful mess.
--
Best Regards,
Jay Shah, FRM
Expect the unexpected!!!