Cognitive Disabilities in Investment

People have brains designed by evolution to figure out whether it's safe to leap to the next branch and when the fruit is ripe. They don't have brains designed to make long-run investment decisions:

[SELECTION RISK](http://www.capitalspectator.com/archives/2006/07/selection_risk.html): The age of self-managed retirement funds can be imagined as a wonderful world, one in which enlightened citizens invest their assets wisely over time so as to live out their golden years in comfort and style. Or so one could theorize. In practice, it may turn out to be something less. How much less depends on any number of factors, starting with the particular skills of the individual.

Alas, those skills, such as they are, may fall short of the minimum required to produce even modest results. Indeed, a new academic study throws more than a little skepticism on the notion that the masses are up to the challenge of managing their 401(k)s as a long-term proposition. The evidence for holding this pessimistic outlook comes from a testing of the most-basic of investing skills: picking the best S&P 500 index fund from a list of four choices, i.e., the fund with the lowest cost.

As tasks in financial decisions go, this one is arguably the easiest. There is, after all, just one factor for selecting the best portfolio: expense ratios. Since S&P 500 index funds are commodities in the true sense of the word, the only differentiating factor is one of price. A simpler methodology for picking mutual funds could hardly be imagined. As such, one could reason that if there's any hope of advancing one's investment station in life, success would reveal itself by investors mastering this important, but ridiculously easy investment hurdle.

Unfortunately, the participants in the study inspire anything but confidence as individuals continue to take control of their retirement assets. Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds, a paper authored by professors from Yale, Harvard and the Wharton School, asks Wharton MBA and Harvard College students to allocate an imaginary pot of $10,000 across four S&P 500 index funds with varying expense ratios and commissions of more than a little significance. In the first experiment, the only related literature the students are given to make an informed decision is the prospectus for each fund. The result? To quote the study authors, "Over 95% of control group subjects fail to minimize fees." In other words, only 5% made the correct decision of choosing the lowest-cost index fund.

In a second test, the students are asked to choose from the same index mutual funds but this time they're given the associated prospectus and a one-page summary that highlights the expense ratios of the four index funds. The results are slightly better, but barely. A still-high 80% of the students still failed to pick the lowest-cost index fund.

But wait--it gets worse. This time, students are handed a prospectus for each fund and a summary sheet that shows each index fund's annualized performance since inception. The professors throw a small curve ball to the students here, if only to test the complexity of life in the real world. That is, the performance summaries represent different time periods. No apples-to-apples comparisons here. But in fact, it's all a trick question. "Because each fund’s inception date differs," the professors write, "this information should be ignored when predicting across-fund variation in future fund returns. In fact, we construct our fund menu so that annualized returns since inception are positively correlated with fees; chasing past returns since inception lowers expected future returns. Nevertheless, this is what our subjects do."

The disturbing result shows that simply by showing investors higher performance numbers--even when those numbers are clearly irrelevant to the choice at hand--the investors make decisions based largely, if not exclusively on those immaterial numbers.

What makes these dismal results all the more frightening is the fact that the test subjects are educated people--most are MBA students at Wharton, among the most prestigious of business schools. The rest are college students at Harvard, a university that requires no introduction. "Our MBA subjects report an average combined SAT score of 1453, which is at the 98th percentile nationally, and our college subjects reported an average score of 1499, which is at the 99th percentile," the professors report.

Suffice to say, the students in question are better educated and therefore better equipped (in theory, at least) to make investment decisions compared with the general population. Why, then, do these students fail so miserably? And while we're asking questions, let's ponder the reality that the general population faces far more complicated investment issues (asset allocation, rebalancing, etc.) in managing real money.

If nothing else, this study underscores the fact that there are more than a few pitfalls in the democratization of finance. Fortunately, there's an easy solution: secure informed counsel on matters of investment strategy. But that introduces another challenge: picking competent advisors. Getting rich, it seems, is just as tough as it's always been.

Comments

[John Emerson]

I would be terrified to manage my own retirement fund. Too much at stake, too much to know, and too much risk even to the smartest investors (and I will never be one of them).

I'd be a very conservative investor, but I've heard stories of conservative investors who had bad luck too.

The proposal to change Social Security from a pooled insurance fund to a form of individual risk investment is what the problem is, not any of the details. It seems that conservatives are not happy unless they see someone losing. "You never should have put your money in XXXX", the winners will happily say to their unlucky friends. "Too bad you had to sell the house".

[David Amann]

Hi John,

I'm curious. Have you ever thought of going to a financial adviser for help with your retirment account? If so, how's the experience been? If not, why not?

Thanks,
David

[jerry]

I would have to assume from observation and bias that most financial advisors really suck at the job.

How many of them will tell you that the obvious no brainer way to invest is first to a) pay down your credit card debt, and b) buy into the Vanguard 500, and if you have the time for more, THEN to consider other funds or stocks. Most won't do this because they need to do things for you like SELL you services and churn your portfolio for them to make their nut. So there is a basic conflict of interest right there. As the study above shows, often the costs of managing an index fund or portfolio is a critical determinant on the performance you will actually see, and so what will an advisor that relies on some function of your transactions for his price to do the performance you see?

Then I have to in a very biased (but correct) fashion point out that the stock of financial advisors mainly come from b arkers. Not the nerds, the mathematicians, the scientists, but from the greedy, the overly socially influenced, former football players, and lawyers.

They wear a suit better than I do, and in fact my puppy dog looks cuter than I do, but I wouldn't ask my puppy dog for financial advice. Ignore suits.

I would recommend the Motley Fool website and books in large part because they do and will tell you first and foremost the steps that are the biggest bang for your buck: reducing credit card debt and sticking your money into an index fund. Then and only then do they tell you about other things you might do like figuring out what percentages of your investments should be in short term vs. long term or foreign vs. domestic stocks.

I work as an engineer for one of the largest manufacturing exporters in the United States. We have a series of financial seminars that come with a free lunch from a local provider of financial services. I attended one. Did they mention index funds at all? At all? No. Amazingly, they actually mentioned CAPM, though they got that completely wrong. But somehow they got CAPM to mean that we should all pay them to figure out what our portfolios should be. Later I asked the organizer how these folks were chosen, and it was mainly that they were friends with the folks in HR. I recommended that our local VP, controller, or CFO be asked to take a look at the presentation and decide if this was information that the company felt was worthwhile.

I figure that when I see an financial advisor or certified financial planner, if one of the first things they mention is NOT the Vanguard 500, then they either know nothing, or they are knowingly out to churn and burn me.

Just say no to b arkers.

Related: apparently according to Kiplinger's, Cheney's own investments are going to perform spectacularly well if the dollar crashes. http://www.smirkingchimp.com/article.php?sid=26772&mode=nested

[anne]

John Emerson makes a point that is honest and humble and generally important. Even simple investment is not so simple or obvious in the learning, and too few investors study simple investing. Conservative professional retirement management as the California state program has given is difficult for individual investors to match though individuals may be entirely adept in other professional areas.

Reading John Bogle or David Swensen is surely recommended, and getting to know what Vanguard has to offer in the way of investing is essential.

[David Amann]

Hi Jerry,

Vanguard is not the cheapest S&P 500 index fund. Fidelity is right now at 10 basis points vs 18 for Vanguard.

Might think about changing your broker on this. Over 20 years that difference alone will cost $5000 on every $100,000 invested in fees.

For a financial adviser that would recommend investing a $100,000 portfolio in index funds, how much would you be willing to pay them on yearly basis to manage that asset base?

Thanks,
David

[John Emerson]

David: Note the "would". My retirement account was very well managed by the State of Oregon.

My real point, however, is that without pooled risk no individual is safe. What if I got a crappy investment counselor? What if unexpected problems showed up in several unrelated companies all at once, and I happened to be invested in all of them? Sure, that's a million-to-one chance, but what if I'm the millionth guy? Without risk pooling, that kind of stuff will happen.

[Bob]

David, if you invest $100,000 in Vanguard S&P 500 you get Admiral class shares with an expense ratio of 0.09 percent.

[John Emerson]

OK, let me ask. Are there any possible or imaginable circumstances (even though highly unlikely)in which an individual would lose a lot by investing in Vanguard or Fidelity? The theory I've seen is that by accepting lower returns and growth you get lower risk. That makes perfect sense, but for an individual investor, is the risk ever zero?

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5452&u=4|31|...

Green Heron Chicks Being Fed
New York City--Central Park, The Ramble.

Three, I am told by my sister, 3 green heron chicks are hatched in Central Park; these are from last year. New pictures will come :)

[John Emerson]

New York is world-class in almost everything, but our heron rookery out here (right next to the pelican rookery and not far from the tern and gull rookeries) has yours beat.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5496&u=4|1|...

Green Heron Landing
New York City--Central Park, Turtle Pond.

Ah, I am quite sure we are lacking in enough herons and pelicans and terns, for who can have enough, but to have herons nest successfully in Central Park is remarkably comforting.

[jerry]

OK, let me ask. Are there any possible or imaginable circumstances (even though highly unlikely)in which an individual would lose a lot by investing in Vanguard or Fidelity? The theory I've seen is that by accepting lower returns and growth you get lower risk. That makes perfect sense, but for an individual investor, is the risk ever zero?

Well the risk is sort of zero if you put your money into government t-bills and not stock market funds. That still carries inflation risk though, I would think.

Great job David, apparently you know the cost of everything and the value of nothing. I.e. I think you missed the point. When the average employee has $100,000 to invest, perhaps it is past time to look for a good advisors, but in all cases, I think that just letting the average investor know what the Vanguard 500 is, and what it represents is far better advice than telling them they need to find a financial advisor.

I suspect that far too many dollars are lost while people fret about what to do with them, than are gained by knowing that now is the time to switch from Vanguard to Fidelity.

[Emma Anne]

"OK, let me ask. Are there any possible or imaginable circumstances (even though highly unlikely)in which an individual would lose a lot by investing in Vanguard or Fidelity? "

You are talking about index funds, I take it? The risk is that the market as a whole will go down. This happens, sometimes for years at a time. That is why most experts recommend that people gradually shift from stocks to bonds as they approach retirement.

The book "Your Money or Your Life" says that the only safe investment is U.S. T-bills. It was written before Bush explained that government bonds are just worthless IOUs, though.

[Reader]

Russell Baker made the point this way (“In the Building Trade,” NYTimes, 1/11/97):

“There is a scheme afoot to privatize Social Security. My son the poor but honest carpenter asked what that would mean.

“’Son,’ I told him, ‘it means in your old age you will be taken care of by the bottom-line guys.’. . . .

“How you would go about getting your Social Security payment into profitable stocks is unclear. My son, the poor but honest carpenter – always quick to whine – complains that stocks, stockbrokers and the stock market are so alien to his way of life that he wouldn’t know how to get into the big bull market.

“Has it never occurred to him to study the market quotations in the daily paper, to take a course in investment strategy, to invite some stockbrokers to his house for champagne and smoked Scottish salmon?

“Thus entertained and oiled, they’d feel obliged to give him tips about how to invest his Social Security payments. They would say things like, ‘Get into perishables.’

“’Dad,’ said the boy, ‘you tell me: How do you get into perishables?’

“What an irritating question. What an exasperating son. What do I know about getting into perishables? Why do I need to know? I got into Social Security in the old days, a mere stripling of 16 years, when government didn’t expect you to know about getting into perishables before they let you into Social Security.

“In that bleak age bottom-line guys got no respect at all.”

[David Amann]

Hey Bob,

Apples to apples -- Vanguard Admiral == Fidelity Advantage (both require $100,000 initial investment)

Fidelity Advantage 7 basis points to Vanguard Admiral 9.

(I don't work for Vanguard or Fidelity. Nor do I hold investments with either firm.)

Hope this helps,
David

[David Amann]

Hi,

Jerry says:

Great job David, apparently you know the cost of everything and the value of nothing. I.e. I think you missed the point.

Well, I was going back to the original point of the Brad Delong's posting. That is, when individuals are presented with equivalent investments, they don't discriminate on price. I thought it was ironic, given Prof. DeLong's intial article, that you were touting Vanguard's index fund when Fidelity's were cheaper.

When the average employee has $100,000 to invest, perhaps it is past time to look for a good advisors

Not hardly. Consider that if you want an asset pool to generate a income stream of $36,000 a year in today's money. You're going to need $720,000 right now. In 20 years (with inflation at approximately 3.5%), you're going to need twice that. So, $100,000 is really a fairly small investment when we're talking about retirement savings.

but in all cases, I think that just letting the average investor know what the Vanguard 500 is, and what it represents is far better advice than telling them they need to find a financial advisor.

I'm not sure about that. Slate reported that the return the average 401k investor got over the last 20 years was app. 4%. However, trustees of the Neb. state pension plan got 8%. (These are not investment professionals.) I have a hypothesis that people might be better at managing other people's money than their own money. But I have no proof.

Lastly, I wasn't trying to be snide or anything to you, Jerry. No offense was intended.

All my best,
David

[David Amann]

John says:
----------------------------------

Are there any possible or imaginable circumstances (even though highly unlikely)in which an individual would lose a lot by investing in Vanguard or Fidelity? The theory I've seen is that by accepting lower returns and growth you get lower risk. That makes perfect sense, but for an individual investor, is the risk ever zero?
-----------------------------

That depends on your time horizon. From Jeremy Siegel's book "Stocks for the Long Run", if you invest your money for 10 years in stocks, bonds, or T-bills, your real return (after inflation) would range as follows:

Stocks: -4.1% to 16.9% compound ann. returns
Bonds: -5.4% to 12.4% compound ann. returns
Tbills: -5.1% to 11.5% compound ann. returns

And there has never been a 20 year period since 1802 where stocks have fallen behind inflation.

So, John, if your time horizon is long enough, you'll do ok.

However, if you invested $100,000 in the SP500 at the height of the market in 3/2000, you're investment would drop to the mid-$60K over the next 3 years before turning around. That type of drop is hard for people to stick with.

Stocks remind me of that quote that Churchill (I think) supposedly stated about democracy. To paraphrase, stocks are the worst long term investment vehicle in the world, except for every other long-term investment vehicle in the world. :-)

David

[John Emerson]

So basically, if you're well enough to put a substantial amount of money into stocks and leave it there, you're set. (Like that's news). But that isn't most people, even after SS is privatized.

The retirement investors worst off would be those who experienced a loss of value about 10 years before retirement. They'd lose the value, but they'd be frightened enough to move into lower-yield bonds too.

Individual retirement accounts seemingly would be worth it, and safe, only if almost everyone were forced to invest in a very sterotyped way. But I think that part of the goal is really to put people at more risk, so that Social Darwinism can do its work.

[David Amann]

Hey John,

I'm a big fan of Social Security and think it should be continued as it is now. I'd be in favor of raising or lifting the payroll tax cap to finance rates.

As for saving and investing, here are the things that are most important.

1. Save more. This is the number one differentiator between retirement nest eggs. Start with 10% of gross income and move up from there.

2. Develop an investment plan that matches your risk and focuses on asset allocation as opposed to picking the "best" asset. If you going on your own, index funds are fine choices. It's more important to develop a plan of say 50% US Stocks, 15% International Stocks, and 35% Bonds than to pick the ideal investment in each category. (This is just an example and shouldn't be considered advice for anyone's specific case.)

3. If you are going to be investing on your own, find cheap index funds that match your asset categories. If you want help, find a good competent adviser that will tell you exactly how they are getting paid and how much you are paying them.

4. Stick with the plan. If you find yourself unable to stick with the plan (because of volatility), then increase the bond portion.

5. Don't forget taxes! Make sure to take advantage of tax-advantaged accounts. As a general rule Roths are better than Traditional IRAs and 401ks.

I've been doing something like this since I started working 14 years ago and my retirement is ahead of schedule.

However, don't buy into the idea that investing is simple or easy. I'd say its the same technical difficulty for the individual investor as doing your income taxes and itemizing income. And emotionally, it can be a lot harder on folks.

If you are not jazzed about it, talk to someone. I'm not jazzed about taxes, so I send mine out to an enrolled agent. JD Powers rates the major investment firms in terms of customer satisfaction. Forrestor does the same. And I think that Smart Money put out an issue recently evaluating the major full-service firms.

Of course, your mileage may vary. Hope this helps.

David

[anne]

There are important comments through the thread, but let's simplify. Vanguard investment grade bond funds may hold corporate or tax free or government bonds, but the funds are superbly secure. The funds are composed of hundreds or thousands of A rated bonds, durations are held reasonably constant, costs are fair. The chance of a significant loss because of default is simply not to be worried about. With a constant duration, the chance of long term loss when interest rates rise is again not to be worried about.

A simply example would be a short term bond fund with a 2 year duration. A sudden rise in interest rates of 1% would lower the price of the fund by 2%, but the yield on the fund would rise by 1% in a month or so. The added yield would pay for the loss in share price in less time than the 2 year duration. Intermediate funds have about a 5 year duration, long term funds have about a 10 year duration.

There is simply no reason to worry about a Vanguard bond fund, the only worry is which to own for your needs.

[anne]

Simple, simple, simple. Begin with Vanguard and ask every possible question about how a simple long term portfolio can be structured.

Total American stock market index fund
Europe stock market index fund
Real estate investment trust index fund
Long term investment-grade bond fund

Notice 4 funds, and America, Europe realestate and bonds are covered. Too risky?

Value stock index fund
Europe stock market index fund
Real estate investment trust index fund
Intermediate term investment-grade or tax free bond fund

Look to how you would adjust the portions invested; only 4 funds to set down on paper to think and learn about.

[John Emerson]

Anne, that is NOT simple.

I'm not investing a retirement fund. I've been inquiring as to what someone should do if they were. I'm doing this with regard to the feasibility of individual retirement accounts. It almost seemed that we had an answer, -- invest in Vanguard or the like -- but then Anne started to say some other things....

One more question: suppose that all retirement money, including SS, were rationally invested in Vanguard or comparable accounts, what would the overall economic consequences be?

[anne]

Ah, I understand, were I investing the Social Security surplus I would structure a portfolio of 70% to 75% in long term Treasury bonds and 30% to 25% in the total American stock market index. Such a portfolio would easily weather a profound bear stock market as in 1973-1974 or 2000-2002, and there should be no price distortion as the stock index is gradually purchased.

[anne]

With individual Social Security accounts, I would have a default account balancing the broad stock and bond market indexes in either a 60% to 40% or 40% to 60% ratio. Then, comes a problem. How do you offer a broad selection of funds in which to invest and protect investors against a range of possible poor choices? Sweden has had success in first insuring an institutional Social Security paytment to retirees, then allowing either use of a default fund or a choice of many approved funds offered at moderate cost. The Swedish market has been robust, most investors have chosen the default fund, others have had mixed experience but in a bull market with Social Security still insured against mistakes.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5458&u=4|18|...

Green Heron in Flight
New York City--Central Park, Turtle Pond.

Oh my :)

[anne]

http://www.calvorn.com/gallery/photo.php?photo=3341&exhibition=3

Great Blue Heron Landing
New York City--Central Park, Harlem Meer.

Imagine making places for green or even blue herons in all our cities. Which would you have? I like both.

[andres]

I'm not surprised that the paper found the results that it did. In microeconomics in general as opposed to investment finance, classic chestnuts such as the Allais and Ellsberg paradoxes have shown that in general individuals do not behave in a consistent, rational manner when you present them with alternatives that have substantially different levels of risks and/or payoffs. In investment decisions it is even easier to get confused by extraneous information such as past performance in different time periods.

Also, it sounds from the abstract as if the writers concentrated only on this first step of the investment process and therefore left aside considerations of the "third degree" and endogenous expectations. As pointed out, to minimize expense ratios is only the first step in investment, and the process of calculating expected future returns, while still subject to logic, is not a straightforward optimization problem given that the optimized function is subject to fluctuating and uncertain probabilities.

[Glendon]

Having seriously studied markets for 35 years and having ridden out several bear and bull markets (the bear in 1973-74 was a killer, at the end of which the Dow Industrials were selling at book value with 6% + dividends), here are my two best suggestions for both learning about investing for the long term and for actually putting your money to work:

(1) The Hussman Strategic Growth Fund, run by John Hussman (PhD economics). Hussman has data on markets going back 100 years and uses it to determine the investment climate (market valuation and market action) and then sets his investment portfolio accordingly, utilizing instruments to hedge against bad markets (but not to capture positive returns in negative markets). Even if you don't invest with Hussman, he provides free weekly commentary and valuable education about current market conditions.

http://www.hussmanfunds.com/

(2) Learn how to invest like Warren Buffett, arguably the best individual investor during the past 50 years, with a single year (2001) showing a negative return (-6.2%) in the past 40 years. Average annual return was 21.5% over that time period vs. less than half that for the S&P500.

http://www.berkshirehathaway.com/letters/2005ltr.pdf

There are funds that try to mimic Bershire Hathaway (Buffett's holding company). But why not do it yourself, using a discount broker and information sources that provide ways of uncovering Buffett-like investments.

https://www.conscious-investor.com/index.html

[John Emerson]

OK, then. What would happen if every single investor adopted a Buffet strategy? Would the Buffet strategy become less successful? What would happen the the overall economy?

[crack]

Unfortunately many if not most 401ks don't offer either Vanguard or Fidelity, and it's even less likely that they offer both. For an IRA how often do you chase the lowest rate? Do you constantly flit your money around to the index offering the lowest fee? David gives us the fees for two as of today, but there have been times in the past where the relative cost was reversed. Should the average investor then move?

[me]

If you take a look at this chart:

http://seekingalpha.com/wp-content/seekingalpha/images/steinhilberassetjuly.jpg

You will see that the US index offered here as the best investment is the worst performing since January 94.

Before you argue time horizons, consider globilization and the integration of world markets.

My only point is that you could invest in the lowest cost US fund and still come out on the bottom of the returns.

Also, remember that Italians invest in Italy and British invest in England and many probably not in the US, so that danger of international investing is overblown, especially considering if you look at the names on your appliances, tires, TVs, you know, all the things you buy.

[anne]

http://www.msci.com/equity/index2.html

To compare current or long term international stock market returns use the Morgan Stanley indexes.

http://www.msci.com/us/indexperf/index.html

To compare sector stock market indexes, Morgan Stanley is also useful.

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

From the perspective of David Swensen, there is no comparable investment company to Vanguard. From mine, as well. There is no quality-cost advantage to other investment companies, quite the reverse.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
7/12/96 - 7/12/06

Australia 13.0
Canada 12.2
Finland 19.1
France 11.6
Germany 8.7
Hong Kong 5.2
Japan 0.7
Netherlands 8.2
Norway 13.0
Sweden 13.6
Switzerland 9.4
UK 7.7
USA 8.6

National Index Returns [Domestic Currency]
7/12/96 - 7/12/06

Australia 12.3
Canada 14.3
Finland 19.0
France 11.5
Germany 8.5
Hong Kong 5.2
Japan 0.3
Netherlands 8.0
Norway 13.4
Sweden 12.7
Switzerland 9.6
UK 9.5
USA 8.6

[Debt Settlement Alternative]

Wow that is quite a handy list you found there anne.