(from The Wall Street Journal’s October 19, 2017 article by Meir Statman. See original post here )
There’s a financial-literacy crisis in the U.S. And it is probably even worse than it seems.
Study after study shows how poorly Americans understand money and investing. Consider this common question posed by surveys: “Suppose you had $100 in a savings account and the interest rate was 2% a year. After five 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?”
This is one of three questions typically used to measure financial literacy. Incredibly, only one-third of Americans older than 50 answer all three questions correctly.
Moreover, questions such as this one, while important, measure only financial literacy. They do little to get at financial comprehension and financial behavior. That is, even if people know financial facts such as the correct answer to this question, they often don’t understand why they may be investing the way they do, and what their behavior means for their current and future well-being. And they don’t understand that not understanding their actions can be even more damaging than not knowing financial facts in the first place.
We do good when we promote financial literacy. We do even better when we promote financial comprehension and the financial behavior that comes out of that comprehension.
So it is important for people to be able to pass a different kind of financial-literacy test—one whose questions and answers will lead the way to smarter spending, saving and investing. We’ve put together just such a test that everybody should take. Those who do—and truly understand the answers—will be smarter investors and consumers because of it.
- A surgeon perfects her surgeries, and increases her rate of success as she performs surgeries more often. Likewise, an investor perfects his trading and increases his rate of success as he trades more often.
True or false?
False: The analogy between a trader and a surgeon is one that many investors make. It makes intuitive sense. But it is wrong. The human body doesn’t “compete” with the surgeon as she perfects her surgeries; it doesn’t switch the heart from left to right. But two traders on the opposite side of a trade compete with each other. A trader might perfect his skills by frequent trading, but will nevertheless lose if the other trader has greater skills or possesses better information.
A trader wrote to me: “Just pay attention. Is the parking lot of Costco totally full 10 hours a day (yes). Did your last two Amazon orders result in (1) A cheaply made item (yes) and (2) An item stolen after Federal Express left it at my door (yes). So why are the experts selling Costco and buying Amazon?”
The answer might be that the experts have more than widely available information about the number of cars in Costco’s parking lot, the quality of Amazon’s merchandise, and the rate by which they are stolen. They also might have narrowly available information about excellent prospects of Amazon, and poor prospects of Costco.
I don’t know. But the point is, neither do you. But rest assured that most professionals on the other side of any trade you make have much better information than you, a nonprofessional. And more often than not, if you’re competing against them—no matter how many times you practice—you’re going to lose.
- Managers of “active” mutual funds are investment professionals who aim to beat the market, whereas managers of index mutual funds aim only to match the market. Active fund managers are experts, with special knowledge, skills and access to narrowly available information not available to amateur individual investors. On average, active fund managers do beat the market. Therefore, amateur individual investors do better to invest in active funds than in index funds.
True or false?
False: Evidence indicates that, on average, “active” mutual-fund managers do beat the market before costs are accounted for, but it also indicates that the returns they deliver to investors, net of costs, lag behind those of low-cost index funds. Moreover, there is little consistency in the ability of active funds to beat the market, so it is difficult to choose active funds that beat index funds consistently. The Securities and Exchange Commission is right to “require funds to tell investors that a fund’s past performance doesn’t necessarily predict future results.”
- Mutual-fund companies regularly include the number of “stars” awarded to mutual funds they advertise. Morningstar awards five stars to top funds in a category. This indicates that it is best to choose funds offered by a fund company advertising five-star funds.
True or false?
False: “Availability errors” incline us to judge likelihood, such as of finding a winning mutual fund, by information easily available to our minds. Some mutual-fund companies exploit availability errors. One ran an ad promoting its four five-star funds. It turned out that these were four of seven five-star funds among its 139 funds. Morningstar classifies the top 10% of funds into the five-star group, but this mutual-fund company had only 5% of its funds in that group.
- Jane is the portfolio manager of the Alpha mutual fund, which beat its S&P 500 index benchmark 10 years in a row. She majored in mathematics at Harvard University, and received her M.B.A. in finance at Columbia University, both with high distinction. This indicates that it is better to invest in the Alpha mutual fund rather than in an S&P 500 index mutual fund.
True or false?
False: “Representativeness errors” lead us to focus on “representativeness” information and overlook “base-rate” information. Some pieces of information make Jane similar to or representative of what we are likely to think of as excellent portfolio managers. These include her Harvard and Columbia degrees, in addition to beating the S&P 500 index 10 years in a row. Yet “base-rate” information tells us that one of 1,024 people tossing a coin is likely to have 10 heads in a row, and the number of available mutual funds greatly exceeds 1,024.
Future returns of Jane’s Alpha mutual fund can be much higher or much lower than those of an S&P 500 index mutual fund. This is good for investors who want a chance to reach high aspirations satisfied by very high returns, but bad for investors whose pain at low return exceeds their joy at high returns.
In other words, just because Jane has done well for 10 years in a row, just because she has two Ivy League degrees, doesn’t mean she will naturally continue to beat an index fund. Nor does it mean that it is automatically better to invest with her. It all depends on what you’re looking for.
- Michael is passionate about protecting the environment and wants his investments to be true to his values. He chooses a mutual fund that excludes stocks of companies harming the environment, knowing that this fund’s annual returns are likely to be 1 percentage point lower than those of a conventional fund. This choice makes sense.
True or false?
True: It’s true for Michael, that is. It is important to understand here that money is for satisfying wants, whether that means secure retirement income, nurturing children and grandchildren, gaining high social status or being true to our values.
A common way of looking at money is to separate the “production” of money from its “use” in satisfying wants—that is, produce the most money you can in a first step, and use it to satisfy wants in the second step. Yet we also properly commingle production and use—think of a choice between a career where you earn much money but are unhappy to come to work, and one where you earn less money but are happy to come to work.
For some people, it makes sense to invest in a conventional fund, get the highest returns, and donate 1 percentage point of those returns to support environmental causes, being true to your values. But for some people, it makes sense to invest in an environmental fund that earns 1 percentage point less than conventional funds but is true to your values.
- You can beat the market by buying and holding FAANG stocks (Facebook,Amazon, Apple, Netflix and Google). “After a decade or so, it has made me stinking rich,” Jim says.
True or false?
False: “Hindsight errors” might well be the most dangerous among the cognitive errors tripping up investors. We know, in hindsight, that FAANG stocks delivered fabulous returns in the recent past. Hindsight errors mislead us into thinking that our foresight is as accurate as our hindsight, but it isn’t. FAANG stocks are as likely to deliver terrible returns in the future as they are likely to deliver fabulous returns.
Hindsight errors coupled with our tendency to extrapolate past returns tempt us to “chase winners,” buying recent winners and selling recent losers. Yet evidence indicates frequent trading is more likely to reduce returns than increase them.
Moreover, when I hear claims such as Jim’s, a voice in me struggles to come out: “May I have an audited statement of your investments?” Is Jim really rich? Did he buy his FAANG stocks a decade ago or only recently? Did he mention all the stocks in his portfolio or just the winning stocks? Examination of a social-networking platform indicates that traders are more likely to contact peers when their short-term returns are high.
Don’t be discouraged when you hear investment fish stories. Remember, people lie about their investments, knowingly or not. As they say: Don’t compare your insides to other people’s outsides.
- The correlation between the returns of U.S. stocks and foreign stocks is approximately 0.90. This is a pretty high correlation, knowing that 1.00 is the highest possible correlation. This high correlation means that there is no benefit in diversifying portfolios globally, between U.S. and foreign stocks.
True or false?
False: Consider the terrible returns of 2008. U.S. stocks, measured by the S&P 500 index, lost approximately 37%, and foreign stocks, measured by the MSCI EAFE Index, lost approximately 43%. The return gap between them is just 6 percentage points, but that indicates substantial diversification benefits. An investor who diversified her portfolio in equal proportions between U.S. and foreign stocks lost 40%, a terrible loss but not as terrible as the 43% loss of an investor who concentrated her portfolio in foreign stocks.
Returns were wonderful in 2009, but this time foreign stocks were the winners, gaining 32% as U.S. stocks rose 26%. The gap between the returns turned out to be 6 percentage points, just as in 2008. An investor who diversified his portfolio in equal proportions between U.S. and foreign stocks gained 29%, a wonderful gain, better than the gain of an investor who concentrated his portfolio in U.S. stocks.
Diversification is guaranteed to bring “mediocre” returns. It will never make you a hero, because you will never have your entire portfolio in the investment with the highest return, but neither will it make you a goat, because you will never have your entire portfolio in the investment with the lowest return. Mediocre looks pretty good when compared to a goat.
If you hate being mediocre, devote 3% of your portfolio to a handful of investments that would make you a hero if you’re lucky, and will vanish into thin investment air if you are not. This way you’ll enjoy the expressive benefits of being a “player,” the emotional benefits of hope, and perhaps all the benefits of being a hero, if you are lucky, with no fear of poverty if you’re not.
- The price of a venti latte at Starbucks is a bit more than $4, amounting to approximately $500 a year if you drink 10 lattes each month. If you are 25, the $500 from just one year’s worth of lattes would compound to a bit more than $5,000 in the 40 years until your retirement at 65, if you save it in an account yielding 6% annually. So it is best that you forgo lattes.
True or false?
False: Sure, for some people this may make sense. But not as a rule. The price of a box of 240 diapers is approximately $46, amounting to about $500 a year if you use 11 boxes to diaper your baby each year until he is toilet-trained. Yet few would advise you to wait and have your baby at 65. Whether latte or diapers, ask yourself whether $500 at age 25 would serve you better or worse than $5,000 at age 65.
Listen to my mother’s advice: “Spend money, but don’t waste it.” Don’t make saving a virtue and spending a vice.
Dr. Statman is the Glenn Klimek professor of finance at Santa Clara University’s Leavey School of Business and the author of “Finance for Normal People: How Investors and Markets Behave.” Email firstname.lastname@example.org.
Appeared in The Wall Street Journal, October 23, 2017, print edition as ‘A Different Kind of Financial-Literacy Test.’