Investors, The More You Know The Better The Chance To Get Rich

Investors, The More You Know The Better The Chance To Get Rich

$DIA, $SPY, $QQQ, $VXX

New research shows that knowledge about investing is  a factor behind the rise in inequality, and that different investors have different levels of sophistication.

The Big Q: Why is that?

The Big A: It may come from varying levels of education. People know what diversification is, but do they know why it works?  I do but other people might not, and might just pick 1 or 2 stocks, increasing their risk without boosting their expected return.

Research shows that this is 1 of the biggest mistakes that people make, if not the biggest.

Unsophisticated people generally do not realize they are unsophisticated. When a person is ignorant, that person does not realize how ignorant he/she is.

This is known as the Dunning-Kruger effect.

People might learn investment basics from their parents, or from their jobs, or from their hobbies. But if you were not fortunate enough to learn about investing, how would even know what you were missing?

This is a problem no matter where one is in the area of financial sophistication. And even those who are smart do not realize how much more they have to learn.

Another reason for information differences is that we can actually buy Key information with money.

The wealthy and the well-funded have access to expensive financial data, which will generally help them earn higher returns. The poor, unable to buy data, will earn lower returns. Thus, the initial differences in wealth will compound over time, with the rich getting richer faster.

Finance researchers realize that differing levels of sophistication are a fundamental, inevitable feature of financial markets.

Researchers have investigate the effect that this will have on the distribution of income inequality. They found that more sophisticated investors tend to get more capital income in the form of capital gains when their portfolios rise in value, dividends, interest payments and the like.

So, if you’re a better investor, your money will make more money.

The effect is made worse because sophisticated investors are able to snap up valuable assets quickly, pricing the unsophisticated out of the market, or leaving them to pick up the scraps.

And that compounds over time.

Income inequality turns into wealth inequality. Differences in investor sophistication will contribute to the future where the rich keep getting richer as their capital turns itself into more capital.

It is is now just differences in investor sophistication that drive inequality.

As society’s average level of sophistication goes up, information-driven inequality increases. This will happen if informational advantages build on each other, the more you know, the better you understand how to learn more, and then the more successful you may become.

Some of the research data support the theory.

Compare the performance of sophisticated investors, i.e. wealth architects: investment companies and investment advisers, to others, and find that the former have been beating the latter at least since the early 1990’s, the age of revolution in information technology.

They also find that sophisticated investors have been taking over the stock market and business (branding and marketing), just as the model predicts.

The rise in stock ownership by sophisticated investors probably corresponds to the information technology revolution, which made financial data more widely available. Stocks tend to have higher returns than other assets. If this continues to be true, the financial future belongs to the sophisticated investor.

This research provides a concrete, plausible mechanism for a Piketty-type dystopia, in which the natural tendency of financial markets is to make inequality explode. And it implies that financial education, of the type urged by many finance researchers, might compound the problem instead of fixing it.

Hence, the rich get richer, businesses grow and out perform because they buy the information needed to make that happen.

The US stock markets finished mixed Friday: DJIA +113.35 at 16314.67, NAS 100 -47.98 at 4686.49, S&P 500 -0.90 at 1931.35

Volume: Trade was above average with about 1-B/shares changing hands on the NYSE as savvy participants sold into the early rally.

The CBOE Volatility Index (VIX) 23.26, -0.21 (NYSEArca:VXX) started the day with a 2-pt loss, but inched higher through the morning, indicating some investors used the early strength to increase their hedges. The VIX then accelerated its rise during the afternoon to end little changed as the slide in the S&P 500 invited strong demand for Southside protection.

• NAS 100 -1.1% YTD
• S&P 500 -6.2% YTD
• Russell 2000 -6.8% YTD
• DJIA -8.5% YTD

Have a terrific weekend.

HeffX-LTN

Paul Ebeling

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