Sophisticated vs. Unsophisticated Investors

Noah Smith has a post on Bloomberg View today talking about research that shows that rich investors tend to dramatically outperform not-so-rich investors because wealthier investors are more sophisticated (generally are more educated in finance). I haven’t read the papers he links to, so my post here will be limited to one thought I have regarding a major point of concern brought up in Noah’s post; that the deviation in performance between sophisticated and unsophisticated investors may increase as the average level of financial sophistication increases (everyone becomes more financially savvy).

Again, I’m not familiar with the model that makes this claim, so this is really just a knee-jerk instinctual reaction. But I don’t think this claim makes much sense, for the simple reason that most of the deviation in performance between the two groups probably comes from the sophisticated investors making fewer stupid mistakes, rather than this group showing its ability to outperform some passive benchmark.

One of the charts shown in Noah’s post, reproduced from this paper, shows the cumulative returns from 1989-2012 for the two investor groups:

Sophisticated investors see $1 invested in 1989 turn into $5.32, while the unsophisticated group only ends up with $3.28. Yet a passive investor putting in $1 into the S&P 500 in 1989 and fully reinvesting dividends would end up with $7.31 (that number comes from here). Now, of course, few if any investors would allocate all their assets in equities; some of that money would go into bonds, which generally return less over the long run than stocks. But the data here seems to focus on equity returns.

So while this comparison is a bit of an oversimplification, I don’t see much credibility to the claim that these two investor classes are likely to diverge over time as everyone becomes wiser about investing. Beating the market is hard. Really hard. (I know as well as anyone; I’m a professional trader). Teach the least knowledgeable investors enough not to be stupid with their investments, and eventually they should catch up to the “sophisticated” class (My job has taught me that so-called sophisticated investors often make the same mistakes as everyone else).

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