More can be better – education edition

Yesterday, I wrote about how analysts who provide more in-depth forecasts for the stocks they cover are better able to forecast earnings, giving them an edge over their peers. Today, I want to focus on education and how more education can give people an edge in their investment returns.

Before I go into this discussion, however, I want to stress that I am not a fan of the trend to send as many people to university as possible. Yes, university graduates on average have higher lifetime incomes, but the dispersion around that average can be large. And by sending more people to university, all you do is increase the supply of jobs with limited demand. Meanwhile, we lack well-trained plumbers, nurses, or accountants and I do not think that people should be trained for these jobs in a three- or four-year university course. I much prefer the German apprenticeship model with a combination of learning on the job with additional theoretical training in specialised schools.

But be that as it may, people are pushed to go to university and that may have benefits other than a degree and on average higher lifetime income. It seems to be that by becoming more educated, people also get better at investing.

Elisa Castagno and her colleagues used the US Survey on Household Income and Wealth to check what kind of returns people earned on their savings while controlling for things like income and other socio-economic factors.

What they found was that people who studied economics had significantly higher returns on their invested savings than other college graduates or people who did not go to college. I know, this is the kind of surprising academic findings you come here to find out…

Of course, you would expect economics graduates to be better at investing than the rest of the population because that is a big part of what they study.

What is less obvious, though, is that college graduates on average have a 3.7% higher return on their savings than non-college graduates. Over a 30-year period of saving for retirement, that means college graduates end up with three times as much wealth as non-college graduates.

And they do so, not because there are mandatory courses in personal finance at universities (I wish there were). Instead, three behavioural changes contribute to these higher returns. First, about one fifth of this increased return comes from higher stock market participation, an effect that has been well-documented in the past. People with better education are more likely to invest in stocks and tend to have higher shares of their portfolio invested in stocks, which in the long run leads to higher returns. The key driver for this behaviour is a better understanding of long-term effects vs. short-term volatility and increased patience (see here for a discussion).

However, the largest part of the outperformance is not driven by higher stock market participation. It is driven instead by increased portfolio diversification and more persistent participation in markets. One of the key slogans in personal finance is that time in the market trumps timing the market. In other words, if you stick with your investments for a long time and don’t buy and sell risky assets in an effort to avoid losses, you will capture more of the upside and in the end be rewarded with the full risk premium on stocks and other investments.

In essence, people get rewarded handsomely for being patient in the face of losses. Instead of chasing the latest, greatest investment trend, patient people diversify their investments and build their wealth slowly. This patience and willingness to forego immediate gratification is something that, in my view, is part of the learning process at university. University training is harder than at school and people have to work longer hours and be more persistent to get their degree than to graduate from high school. And this “grit” is what makes us better investors as I have discussed here.