I read a fascinating article in The New York Times’ February 26, 2012, business section entitled, “What High IQ Investors Do Differently.”
The article discussed a study of investors from Finland and compared investment results of investors with high IQ scores to investors with lesser IQ’s. To no one’s surprise, the high IQ investors had better risk-adjusted returns. However, what was revealing to the authors of the study was how the high IQ investors received higher returns. Surprisingly, the members of the high IQ group were not great stock pickers or market timers. Instead, they tended to follow basic rules of successful investing.
First and foremost, this group of people made sure their portfolios were diversified: they didn’t put all their eggs into one basket. They also stuck to their process of investing a larger portion of their assets in the stock market. Plus, they favored small-cap stocks which have traditionally outperformed the broader market; the investors were willing to live with the extra risk of small companies for the higher potential return. Finally, this group also invested in stocks which were low-priced and out of favor. This technique is called “value investing,” and, incidentally, it is how Warren Buffett picks his investments.
The takeaways for you as an individual investor is; first extract yourself from the culture of stock picking, market timing and watching the “financial media” on television. The first two don’t work and the latter is there to sell you detergent, cars etc. Also consider that portfolio diversification is your buddy, under valued stocks outperform growth stocks and small companies have outperformed large companies. But since there is no free lunch in the investment world these extra returns come with extra risk. I’ll also throw in that you should emulate investment styles of people who are smarter than we are such as Warren Buffett.
To see if this investment strategy has merit, let’s do a ten year back test (March 31, 2002- March 31, 2012), using a diversified portfolio of index funds from Dimensional Funds Advisors (DFA). DFA specializes in small and undervalued companies. Our portfolio is comprised of 60% stock funds and 40% bond funds. Both stocks and bonds are globally diversified and the stocks funds have more value than growth stocks and more small than large companies.
They also hold REITS (commercial Real Estate as well). The ten year annualized return of such a portfolio was 7.49%. Now let’s compare that to the 10 year return to the S&P 500 index which was 4.2%. Although not guaranteed in the future using these techniques helped us achieve a higher return and, because of the bonds, lower risk. A reasonable investor can’t ask for much more!
Editor: Kate Bartolotta