Investment no-no’s not just for novices

Marketplace Staff Jan 12, 2007

KAI RYSSDAL: Most of us shop hard for big ticket items like a car. After all, why pay more than you have to? But then we turn around and don’t shop smart for a more pricey item. An investment portfolio can cost tens or hundreds of thousands of dollars over your lifetime. But we rarely look for bargains when we shop for things like mutual funds. You can blame it on how most of us, even financial elites, behave around money. Marketplace’s Steve Tripoli explains.

—————

STEVE TRIPOLI: Why do so many people buy mutual funds that charge high fees? Three researchers in behavioral economics couldn’t figure it out. So they took a bunch of financially savvy graduate students from the University of Pennsylvania’s elite Wharton Business School. The students were given a hypothetical $10,000. They also got prospectuses describing four index mutual funds that track the S&P 500. They were told to invest that $10,000 however they liked among those four funds. They could even put it all in one fund. And guess what?

BRIDGETTE MADRIAN: Only a very small fraction of students picked the lowest fee portfolio, which would, of course, be the sensible thing to do in this case.

Sensible because one S&P 500 index fund has pretty much the same investment return as any other. That’s why the researchers, including Bridgette Madrian of Harvard, who you just heard, used index funds in the study. But investment returns aren’t the only way to measure a fund’s gains over time. Fees for these funds ranged from $309 in the first year to $589. That info was included in the students’ prospectuses. Yet almost all of them failed to stick all their money in the lowest cost fund. Again, Bridgette Madrian.

MADRIAN: One conclusion is that investors don’t know what information is most salient in making an asset allocation decision.

Hmm, the researchers thought. Maybe the prospectuses were too long, or too confusing. So they tried again. But this time, each student got a one-page cheat sheet where all the fees were in large, bold numbers. Results? Over 80 percent still didn’t go for the lowest cost fund. Harvard’s David Laibson is another of the researchers.

DAVID LAIBSON: If Wharton MBA students don’t understand this on something as simple as an index fund, we’ve got to worry more broadly about the general public’s understanding of the financial products that they’re buying, particularly when those products get more complex than an index fund.

Laibson and Bridgette Madrian say people just don’t understand how important fees are. Annual fees for index mutual funds range from a tenth of a percent of the money invest to about 2 and a half percent. That’s the same as buying a box of Cheerios for $50 when you can get it for $2 elsewhere. But Laibson says that’s far from the worst of this.

LAIBSON: A tiny difference in the fee compounds over time and can make an enormous difference in terms of your final accumulation for retirement.

If you’re paying even an extra 1 percent a year in mutual fund fees, that can knock your final retirement kitty down by 30, 40, even 50 percent. Laibson says one problem is that most mutual fund ads don’t talk about fees. They talk about past investment performance. Yet by law, they have to say in the same ad that past performance is no indication of future returns. So they’re side-stepping the important stuff and playing to our own bad behavioral instincts.

LAIBSON: It’s a very natural intuition that what happened yesterday will happen again today. So, buy and large, though it’s hard, you kind of want to put blinders on yourself and not pay too much attention to what the fund did last quarter, last year or even over the last few years.

In a separate experiment, Wharton students got that one wrong too. They chased seemingly hot past returns. But at least we can learn from their mistakes. Here’s what to know — fees are very important. So shop for the lowest in the fund class you want and fight your urge to chase past returns. Because if you don’t overcome the bad money instincts wired into most of us, there are lots of folks out there who are more than ready to take advantage.

RYSSDAL: Steve, hang on just one second. Don’t go anyplace. You mentioned in your piece that a lot of people don’t see the importance of mutual fund fees. But I don’t know, it’s my experience that you can’t even see the fees to begin with, that they’re so deeply buried in there.

TRIPOLI: Unfortunately, that’s true, Kai. You know, the cost of buying and owning mutual funds is not as apparent as most other prices are. In fact, it’s horribly unapparent to a lot of consumers and most of the industry, I think, likes it that way.

First of all, they’re buried in a prospectus where they’re hard to find as well as being hard to interpret. And then there are fees beyond the annual charge. Some funds have so-called loads, which is an upfront percentage you pay whenever you put money in. Loads are a bad idea if you’re an investor. And then there are so-called 12b1 fees some firms tack on for advertising. That’s another one to avoid. It’s tough to add it all up.

RYSSDAL: Well what’s the average investor to do? I mean, you know, you and I study this a lot and we can’t find them. What can you do besides reading more about them and looking for them?

TRIPOLI: Well, you know, a word first about financial literacy education that a lot of people say is the answer. It’s not a short-term solution. That’s because, quite frankly we need so much of it in this country right now that it’ll take a generation to educate most folks adequately. So financial education alone can’t penetrate quickly or broadly enough.

The folks I interviewed for this story say government regulators may be starting to realize that and they’re also starting to see that the current state of consumer disclosures may not be adequate. So don’t forget, all those prospectuses investors get were an attempt to give consumers what they need to choose mutual funds wisely but the behavioral economists in the story keep proving that most of us still don’t choose wisely. So it may be more on the regulatory front.

RYSSDAL: Well, what’s that going to be? I mean if they tried with prospectuses. I mean, come one, they go straight into the recycling in my house. What more regulation can there be?

TRIPOLI: You know, one possible model is the food nutrition labels we now see on things we eat. They’re short. They give a standard set of information and they’re easy to understand. You know they’re by no means perfect, but now a lot more folks can tell whether that box of crackers they pick up has more fat or sugar or salt or transfats than they want to eat. So a label like that for mutual funds could tell you more about whether a fund has too many of those empty calories called fees.

RYSSDAL: Empty calories, yeah. You know it’s a different retirement and personal finance planning world out there. I mean stakes are way higher now than they were a generation ago. What are the near term solutions that are going to help with a problem that we’re not going to, you know, realize the full effects of for another 25 years?

TRIPOLI: Well there’s one fact that the behavioral economists find intriguing it’s that person who runs your company’s 401k retirement plan, the plan administrator. Those people, overall, are more savvy than the rest of us. They also control most of our choices of retirement funds because most of what you invest for retirement is through funds that they choose for your company’s plan. So the thought is to get this much smaller group on board with offering only a menu of low-cost funds in company plans. That’s a good way to short-circuit our own bad behavioral instincts. It just takes the bad choices away and then we’ll all have a little breathing room to get educated about this new world and we won’t lose an arm and a leg while we’re doing it.

RYSSDAL: We’ll talk about it again, I’m sure. Marketplace’s Steve Tripoli. Thanks, Steve.

TRIPOLI: Thanks, Kai.

We’re here to help you navigate this changed world and economy.

Our mission at Marketplace is to raise the economic intelligence of the country. It’s a tough task, but it’s never been more important.

In the past year, we’ve seen record unemployment, stimulus bills, and reddit users influencing the stock market. Marketplace helps you understand it all, will fact-based, approachable, and unbiased reporting.

Generous support from listeners and readers is what powers our nonprofit news—and your donation today will help provide this essential service. For just $5/month, you can sustain independent journalism that keeps you and thousands of others informed.