Cognitive Disabililities in Investment

People have brains designed by evolutionto 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.