Are individual investors equipped to make basic financial decisions?

In discussions of finance and investment, it is routine to see disclaimers such as “may lose value,” and “past performance is no indication of future results.”

However, as we have pointed out in our paper Financial charlatanism: The effects of backtest overfitting on out-of-sample performance, even this may be a bit optimistic, as certain investment strategies, marketed to the public as money-winning, actually might be pretty much guaranteed to be money-losing, particularly when fees and other expenses are considered.

These considerations raise the question: Are individual investors equipped to make the sorts of financial decisions that increasingly are required of them in today’s investor-beware world, to gain a good return on their investments and avoid financial fraud?

After all, for most people, straightforward defined-benefit pensions that guarantee a proportion of one’s income at retirement have gone the way of floppy disks and land-line telephones. Instead, the worldwide bumper crop of baby boomers (just in the U.S., 77 million Americans were born in the period 1946-1966) are facing a brave new world where they, more than any generation before, are personally responsible for their future financial well-being.

The degree and fashion to which this is true varies widely among the advanced democracies. For instance, in Canada “social security” provides about half what it does in the USA. In Australia, universities place 17% of income into superannuation funds; in New Zealand it is 7%. In Canada, pension savings are taxed as they come out, whereas in Australia they are not taxed if taken as annuities. In continental Europe, mandatory retirement rules still exist, while in the English speaking world such rules are largely a thing of the past.

Wharton researcher Olivia S. Mitchell points out that most boomers have failed to plan and save adequately for retirement. For example, more than half of today’s retirees in the U.S. will rely on Social Security for more than 50% of their total income. Thus most will experience a rather severe drop on standard of living upon retirement, or will exhaust their savings long before they depart this world, leaving themselves at the mercy of family members. At the least, it is clear that many will need to lower their expectations for life after retirement.

So how well equipped are today’s baby boomers (and others of all ages) to manage their personal investments? Are they doing the right thing? A 2012 “Quantitative Analysis of Investor Behavior,” analyzing U.S. individual investor experience, found the following:

  1. Over the past 20 years, the average individual equity (stock) investor underperformed the S&P500 by an average annual rate of 4.32%.
  2. In 2011, the average equity-fund investor lost 5.73%, compared with 2.12% for simply holding the S&P500.
  3. Over the past 20 years, the average fixed-income (bond) investor underperformed the Barclay Aggregate Bond Index by 5.56%.
  4. Both equity and fixed-income mutual fund investors have underperformed market indices on a one-year, three-year, five-year, 10-year and 20-year basis.
  5. The average investor in “asset-allocation” mutual funds outperformed the average equity investor only six times in the past 20 years.
  6. The average fixed-income mutual-fund investor has not kept up with inflation, whether measured on a five-year, 10-year or 20-year basis.

It is increasingly clear that the principal reason for this abysmal performance is that individual investors are poorly educated and informed. As the U.S. Securities and Exchange Commission noted in a 2012 report, “investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.”

For example, in a 2011 study (access fee or .gov IP address required), researchers Annamaria Lusardi and Olivia S. Mitchell asked Americans the following questions:

  1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow? (More than $102, Exactly $102, Less than $102, Do not know or Refuse to answer)
  2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account? (More than today, Exactly the same, Less than today, Do not know or Refuse to answer)
  3. Please tell me whether this statement is true or false. “Buying a single company’s stock usually provides a safer return than a stock mutual fund.” (True, False, Do not know, or Refuse to answer)

The results are truly disheartening. Only 64.5% answered “More than $102” to question 1, only 64.3% answered “Less than today” to question 2, and only a bare majority (51.8%) answered “False” to question 3. No wonder individual investors are doing so poorly!

These results are closely connected to the larger issue of education in mathematics and science in today’s world. As two of us have argued at length, e.g., Math Drudge blog A and Math Drudge blog B, a growing plague of mathematical-scientific illiteracy threatens the economic well-being of numerous first world nations, particularly in the U.S., U.K. and Australia. Canada and New Zealand are so far performing a tad better, but likely not enough to change the basic issues.

But now, given the results mentioned above, it is clear that general mathematical-scientific illiteracy also threatens the personal investment savings of many millions worldwide. “Investor beware” is no longer good enough.

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