The naivety of US investors stands out in a new academic study that highlights their sometimes dismal decisions about investments

April 14, 2013 3:07 am

Many US pension investors are gullible

By Ellen Kelleher

The naivety of US investors stands out in a new academic study that highlights their sometimes dismal decisions about investments.

Research from two University of Pennsylvania professors shows the mistakes Americans commit when they move money into their 401k retirement plans are numerous. They range from under-investment and making poor choices about how to diversify portfolios, to paying expensive fees to pick up underperforming mutual funds.

The study by Profs Jill Fisch and Tess Wilkinson-Ryan, to be published soon in the University of Pennsylvania Law Review, is the latest exposé of Americans’ terrible investing habits.

It follows a study by the regulator, the Securities and Exchange Commission, of financial literacy levels in the country last year, which came to the pessimistic conclusion that many US investors fail to understand concepts such as inflation, diversification, investment costs and compound interest.

Almost as unsettling, investors taking part in the Penn study found it difficult to identify and avoid inferior mutual funds. The results also reveal that “naive” diversification strategies drove many of their decisions about which mutual funds to buy. “Our study raises particular concern that investors and employers as well do not understand what they are supposed to do in investing for retirement,” write Profs Fisch and Wilkinson-Ryan.The researchers devised a simulated web game in which participants were asked to invest $10,000 across a range of 10 fictitious mutual funds; they were told to invest with the aim of retiring in 30 years. The fund’s current expense ratios were displayed, as were their risks and the funds’ top 10 holdings as plucked from real mutual fund prospectuses. Some pairs of funds were nearly identical, but just varied in the heft of their fees.

“We collected information on how subjects allocated their $10,000, as well as the specific clicks that each subject made in order to view additional information about the funds,” say Profs Fisch and Wilkinson-Ryan.

The results suggest some investors were less naive than others. The researchers note most participants chose a “reasonable” debt-to-equity balance in their portfolios. Many flocked to the low-fee index fund and the low-fee managed fund, two investments that were the most attractive.

But when it came to diversifying, the study participants proved to be less skilled. As many as a third were guilty of “diversifying naively” and investing in all 10 funds, despite facing higher expense ratios on some. And more than two-thirds in both control groups who invested in the low-fee index fund also bought into the high-fee product. A shocking 68 per cent of participants in the second group examined opted to allocate at least some money to a higher-fee actively managed fund that was just a “closet” index fund. Most people also threw some money into a money market fund with low returns even though they were told they were investing over a 30-year horizon in which liquidity concerns were minimal.

Another common problem is that investors tend to delegate their decisions by choosing actively managed mutual funds, target-date funds (which turn portfolios over at a particular trigger date depending on one’s age and investment needs), or professionally managed accounts.

“Delegating responsibility for investment decisions make investors vulnerable to the choices of professionals, choices that may be opaque, shielded from market discipline or tainted by conflicts of interest,” the researchers say.

The study results showcase the gullibility of participants. But Profs Fisch and Wilkinson-Ryan conclude there is some hope yet for their countrymen. With proper education, the “predictable, costly” investment mishaps can be corrected, their research suggests.

Offering guidance on the fees funds carry, for example, encouraged investors to shift their allocations towards lower-cost products.

The professors say: “When fee information is presented simply, educating investors about the importance of fees updates their investment beliefs, motivates more thorough research, and yields higher-yield investment choices.”

The flip side of this is that just simplifying fee information without offering guidance on fees seems to be of limited value to investors. “Without the fee instruction, our subjects tended to diversify among the investment options provided, to pay average fees, and to obtain average performance from their investments,” the research says.

The retirement industry in the US has been transformed by the arrival of 401k retirement plans at companies, which offer an array of mutual funds to pick for retirement.

These programmes are revolutionary as they shift the bulk of the burden of investing for retirement to employees who are required to contribute a bigger chunk of their salaries towards mutual funds. Companies tend to match their contributions by offering a small percentage towards their investments.

The 401ks are a concern, as they create a situation where people with poor investment knowledge are now investing for retirement with little guidance from experts.