You're an Idiot. Statistically Speaking.

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Sept. 11. With permission, we're reproducing it here in an edited form.

He was a dreamer, a thinker, a speculative philosopher... or as his wife would have it, an idiot.
-- Douglas Adams

The number of times in which the terms "Securities and Exchange Commission," "182 pages," and "spellbinding" can be used in the same sentence is certainly not very large. And yet write that I must. As part of the Dodd-Frank Act, lawmakers directed the Commission to figure out how much average investors knew about the stocks and mutual funds that they held.

Here's what they found: You are an idiot.

No, no, not you specifically, Frank Snardgaard of Jamestown, North Dakota. Everyone.

Statistically, the SEC found that American investors -- regardless of age, race, or gender -- "lack basic financial literacy," and that they generally do not understand even "the most elementary financial concepts such as compound interest and inflation." The surveys suggest that certain sub-groups, including the elderly (I'll come back to this in a moment), "have an even greater lack of investment knowledge" of concepts like the difference between stocks and bonds, and are unaware of investment costs and their impact on investment returns.

Let me reemphasize one word here, because it's important. Investors. They didn't just ask any Americans, they asked people who are already investing. One would hope that this set of Americans have a greater level of financial acumen than those who are not investing, and yet they were consistently tripped up on questions like "what's a stock?"

Don't worry, there's a committee
The SEC's financial literacy committee offered a few potential cures for such widespread financial illiteracy, including developing targeted investor education programs, increasing the number of investors who research investments before investing (their words, not mine), and promoting Investor.gov as a primary resource for investing information. These goals are absolutely wonderful for keeping bureaucrats employed, but will do nothing to move the needle on investor knowledge or sophistication. Do they really think our guy Snardgaard, who does no research whatsoever before buying a stock or a mutual fund, is suddenly going to think "Hey! I reckon I'll saunter over to Investor.gov, the primary federal government resource for investing, to learn about stuff I don't even realize I don't know!"

There are two ways to improve financial literacy. First, teach it in schools. It is a poverty that the most uncommitted parking lot scholar coming through the American school system doesn't have a firm grasp of the functions and power of compound interest. I submit that the collective wealth squandered in this country due to poor understanding of basic things like what a 27.9% APR rate means is nearly unimaginably large.

And second, the producers of documents related to various securities have to want their investors to be educated. This isn't an academic discussion: As we've noted in the past, the average mutual fund investor trails the performance of the funds he or she holds substantially by virtue of buying and selling at the wrong times. Financial illiteracy is costly, and even though the very construction of mutual funds allows investors to put their investing in the hands of professionals, mounds of evidence suggest that they would be far better off with a higher level of understanding and knowledge about the financial products they own (and how those professionals are paid).

But this study strongly suggests that it isn't happening. Survey participants were tasked to read a summary prospectus from a made-up mutual fund. Not surprisingly, many found the document poorly written and user-unfriendly. The test results for reader comprehension of these documents were fairly dismal.

You should think of this as a love letter
This is a subject near and dear to our hearts. Educating investors is the very reason The Motley Fool got into business, and when we (Motley Fool Asset Management) decided to open mutual funds, it became a non-negotiable component of our strategy. Each month, the Fool Funds portfolio team takes hours of our time to write to you with the goal of educating, entertaining, and yes, enriching you. We don't have ghost writers -- we do it ourselves.

The reason we do this is threefold. First, we believe that the overall returns of the fund will be enhanced if we are able to attract the right kind of investor (and dissuade the wrong kind). Second, we are fascinated by the pursuit of investing mastery, and one of the best ways I know to crystalize thoughts is to get them down onto paper. Finally, we see the statistics on the disparity between the returns of the average mutual fund return and its investors and, frankly, it makes us want to throw up.

It is possible for a mutual fund to put out 5-star, rock-star, all-star, throwing-star level results, and for its investors to still lose money because they get greedy when they shouldn't and panic when they shouldn't. And not only is this possible, it happens all the time. Maybe other fund managers are OK with this -- after all, they can't really control when investors buy and sell. We are very much not OK with this. (By the way, the same thing goes for stocks, ETFs, any investment you can think of. You can hold the winning lottery ticket -- a company that goes up 10-fold in 10 years -- and still end up losing money.)

I like my job. We're all passionate about what we do here. But quite frankly, if I look back 10 years from now and we've done well and our investors haven't, I won't consider it time constructively spent. Financially savvy investors make better decisions. Not always, but enough to make a difference.

The good news about this report is that the SEC is on the case, so certainly we can expect more attention to the plight of vulnerable investors in the future.

You'd like to think that, wouldn't you.

JOBS for fraudsters
One of the provisions of the newly signed Jump-start Our Business Startups (JOBS) Act is a loosening of the restriction on hedge fund advertising. Technically, the law instructs the SEC to end its ban on "general solicitation" for certain private offerings, just so long as the firm takes reasonable steps to verify that it's only selling to "accredited investors." (An accredited investor is someone who meets either an asset threshold of $1 million excluding the value of one's primary residence, or income of $200,000 per year, or a combined $300,000 for married couples.)

When Congress instructs a federal agency to do something, that agency has lots of leeway in how it actually chooses to implement. The SEC could have said "We will make XY & Z changes to our current definitions in order to protect investors from fraud." Instead it essentially rolled out the ball and said, "Have at it, boys! And promise no cheatin'!"

Mutual funds such as ours have enormous levels of reporting and filing and stamping and checking of facts that we must submit to the SEC before they're allowed to accept investor money. Similarly, public offerings like IPOs have massive prospectuses and stultifying rules to be followed. Conversely, now "unregistered" or "private" offerings have much lower reporting thresholds, and reporting requirements that are the equivalent of "say as much -- or as little -- as you like."

You're just whining about rich people, right?
But at least they're limiting this to "accredited investors," right? Those are the rich folks, they can handle it! The theory is that accredited investors tend to be more sophisticated and more capable of absorbing loss should a risky investment go bad. This would be great were it not so blessedly, horrifyingly wrong. It's not like there is some actual accreditation authority. There is no test. You don't get a sticker, or a stamp, or a silver star with an oak cluster to designate yourself as being accredited. If you have a pretty successful-sounding job or a country club membership, you can probably pass yourself off as accredited to someone who takes "reasonable effort" to determine your status.

Ultimately, if an investor wants to lie about being accredited, he or she can do just that. But look again at the asset test -- $1,000,000, excluding your house. Know what isn't excluded? Retirement accounts. Many retirees have large retirement accounts because they have saved, and saved and saved throughout their working lives, money that they will need to live on for another 20-plus years. Yes, they're millionaires, but they sure as hell aren't rich.

Consider the SEC's proposed rule change in light of the results of the investor survey, and I hope you're as horrified as I am. Given the large amount of skepticism the SEC had previously shown about the JOBS Act, I find its new rule to be stunning. If it goes through unchanged, it will allow hedge funds to say as much or as little about their offerings, just as long as they, again, make a reasonable effort to determine whether they're selling to accredited investors.

My inner cynic thinks that the SEC knows the JOBS Act is a disaster and wants to ensure that as much of the stink falls back on Congress as possible. I fear that it knows that investor accreditation is basically a mass-affluent designation, that investors have been proven to not understand difficult financial questions like "what is a stock?," and hedge funds don't have to register or say very much, and so it understands that what is coming is a tidal wave of fraud and thinks it best to let it roll through as quickly as possible.

And lest you think I'm overstating the problem, let me allow you into our world as investment managers for a moment. Obviously we market our funds, and we do so under a fairly draconian set of rules. Many, many times market research firms have offered to sell us lists of elderly investors. (And each time, we've refused the offer.) Why elderly? Because that's where the money is, my friend.

I wish I were making this up.

There is still time to comment at the SEC website on this rule -- you can do that by clicking here. As for the poorly named, sure-to-be-destructive JOBS Act, it's now the law of the land. Your commentary is limited to how you vote in November.

Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below.


Read/Post Comments (22) | Recommend This Article (86)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 24, 2012, at 5:42 PM, TMFCrocoStimpy wrote:

    Bravo, Bill. Bravo.

  • Report this Comment On September 24, 2012, at 8:08 PM, lwbaum wrote:

    To get started at introducing investing education into schools, the Motley Fool could write some curriculum for schools or individual teachers who want to introduce it as an elective course. At first, it could be simply an outline of what to learn week-by-week for a one-semester financial literacy course, with links to existing Fool articles or other easy references.

    There are already many schools that teach some of this. For example, I had an economics course in high school in ~1982. But the Fool can help increase coverage of this important topic in schools.

  • Report this Comment On September 24, 2012, at 8:48 PM, mountain8 wrote:

    "they asked people who are already investing."

    I need to ask for a little clarification. Are we talking people who have a broker, people like me who make their own decisions, people who "invest" through their company retirement plans, or all of the above.

    If they include people and their 401s or company supported IRAs, I can see it. Most of them just put the money in and forget it.

  • Report this Comment On September 24, 2012, at 8:50 PM, mountain8 wrote:

    That's not saying that isn't a good way to accumulate wealth. I'm just saying they don't know much about what they are doing. One doesn't have to know much about a savings account.

  • Report this Comment On September 24, 2012, at 8:50 PM, mountain8 wrote:

    By the way, I love your writing style.

  • Report this Comment On September 24, 2012, at 9:08 PM, mountain8 wrote:

    Your bio doesn't tell me much but I'm just curious if you might have one of these -silver star with an oak cluster. Doesn't qualify you to make financial decisions of course, but it would tell me something about the type of person you are. Just curious as you mentioned the award in your article. Most people don't even know what one of these is.

  • Report this Comment On September 24, 2012, at 9:10 PM, mountain8 wrote:

    "Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below."

    I'm curious about this also. I know he's busy... but. I have to assume he can't type.

  • Report this Comment On September 24, 2012, at 9:43 PM, TMFCrocoStimpy wrote:

    @mountain8

    Bill Mann cannot comment here because he is employed by Mötley Fool Asset Management, which has a strict legal separation from The Mötley Fool editorial side of the business. Even the appearance of a conflict of interest between the two sides of the business is wholly unacceptable, thus Bill can't participate in a discussion of this sort on these boards.

  • Report this Comment On September 24, 2012, at 9:52 PM, TMFCrocoStimpy wrote:

    I suspect that the reference to " people already investing" probably includes folks with 401(k) accounts, which emphasizes the point that a large number of people participate in the markets without understanding them. That may be where the greatest financial tragedy exists, that people have been almost universally steered into these ways of saving for retirement, but haven't been educated adequately about what they are getting into. The "trust me, I'm a professional" mantra seems to have shown a rather dramatic correlation between the creation of the 401(k) and the substantial growth of the financial services industry.

  • Report this Comment On September 25, 2012, at 8:19 AM, A2Matty wrote:

    Kudos. Great article. As a CPA and long time investor...I tend to agree that I'm an idiot! I'm actually a "Fool," but every time I hang on to a stock for that long ride down (praying all the way that it will turn around (CHK - ignoring every possible sell sign in bright neon lights) - I can be an idiot. What really amazes me is that the feds are right. Dodd-Frank won't help this though - especially when they are easing filing restrictions on IPO's. I have friends (as I'm sure every one on here does) that have no idea what they're investing in, no idea why they should set aside money each month, etc. I learned compound interest in 8th grade algebra, and have parents who began drilling this into my head from then on. My family actually started a "stock club" when I was in 7th grade (wendy's was our first buy (at 4 1/8th - remember those days). We certainly weren't a wealthy family - so I'm impressed my parents did this. I've got to think it starts there. We can't count on schools to teach our kids this stuff (though a class on investing and personal wealth management certainly makes more sense than some of the garbage they take).

    If you want something done right...

  • Report this Comment On September 25, 2012, at 9:51 AM, Darwood11 wrote:

    I appreciate Bill Mann's timely article.

    I freely admit I'm one of the idiots. My parents didn't "invest" in the strict sense, but they did put savings aside for retirement, and they taught me the value of working, living below my means and saving. Nevertheless, I began with some real headwinds because I lacked fundamental understandings of the stock market in particular and "investing" in general.

    Adding to the problem was older business associates who purchased stocks. Some apparently did well, but didn't say how or why. Others got burned, repeatedly, and the earliest complaints I remember were in the early- to mid-1970s that "It doesn't matter what I buy, it all goes down."

    On the bright side, I did have an excellent math background and became adept at PCs and that includes spreadsheets. These good education foundations probably saved me. That however, does not prepare one for dealing with brokers, reading the fine print about loads, fees and the latitude provided to active managers in making selections for the funds they manage.

    The last time I got burned was before the 2008 financial disaster. I discovered my broker had gradually steered me into funds that were top heavy in financials; mostly this seemed to be a consequence of the decisions of the fund managers. I re-distributed my portfolio. However, there were fees, etc. That was actually only a minor setback, because I avoided the worst of the big show.

    But it has been a somewhat difficult journey, and definitely not fun. I continue to learn, and make decisions both good and bad. I have learned to steer clear of stock in certain companies, or companies that have what I would call a certain profile.

    As some have commented, we are all investors if we have any retirement funds at all. We can put them into bond funds, money market funds, or stocks and commodities. I'm convinced these decisions do make a long term difference.

    Ultimately, we must choose to take responsibility for our actions if we want to have any personal power in our lives. To be responsible requires education and making informed decisions. .

  • Report this Comment On September 25, 2012, at 10:36 AM, Lucaskasan wrote:

    Absolutely financial literacy should be a requirement in our schools, and should have already been implemented decades ago. I have taught financial literacy in summer programs for kids 9-14. they complain because their parents made them take the class. they complain it is too much like real school because it involves math, not just playing around (like the ever-popular robot building class). But honestly, not one of them can tell you 10% of a given number without scribbling on some scratch paper, and many cannot even to that.

    Motley Fool should hire a curriculum designer (like me) who actually knows what kind of prior knowledge the kids possess and has teaching experience.

  • Report this Comment On September 25, 2012, at 3:48 PM, tomd728 wrote:

    Simply a terrific piece by B.M !

    The most intolerable idiots are Chris Dodd

    and Barney Frank ....

    The "Dodd / Frankenstein" as many call it,is a mess.

    Thank you both for retiring and good luck on the rubber chicken circuit.Should one of you choke....don't call me.

    Tom

  • Report this Comment On September 25, 2012, at 3:58 PM, JadedFoolalex wrote:

    Not to sound cold-hearted and mean, but if your greed allows you to think that 2% plus 20% is a reasonable price to pay to a hedge fund, then you deserve everything you get! Even Mr. Buffett thinks it's ludicrous to pay those kinds of fees and he should know!

  • Report this Comment On September 29, 2012, at 12:16 PM, ershler wrote:

    I've only had 1 class that discussed personal finance and investing in 16 years of education. That was an elective engineering economics class where the professor decided this was more important then what was on the syllabus .

  • Report this Comment On October 01, 2012, at 11:56 AM, myother wrote:

    Yes, people are in charge of their 401-k retirement accouts that know nothing about investing and will lose lots of money. I've been in that boat and still am somewhat(chasing returns). I don't want to do it. It's almost a full time job on top of working, kids, taxes, and everything else we expected to stay on top of.

  • Report this Comment On October 01, 2012, at 11:58 AM, myother wrote:

    Yes, 1 million in retirement accounts is not rich. It is just someone who worked and sacraficed their whole life. I don't even know if it is enough for retirement.

  • Report this Comment On October 05, 2012, at 3:12 AM, Clint35 wrote:

    Well at least Uncle Sam and the SEC are on the case. I feel so much better now, LOL. Good article.

  • Report this Comment On October 05, 2012, at 7:20 AM, skypilot2005 wrote:

    I know. Let’s create The Consumer Financial Education Bureau. The Motley Fool can get behind that like you did the Consumer Financial Protection Bureau. Have a few meetings at the White House to kick things off.

    It’s all about personal responsibility. The information is out there.

    I am all for covering the topic in high school within currently offered classes.

    Sky

  • Report this Comment On October 05, 2012, at 12:23 PM, thesafesurfer wrote:

    I am an idiot. That's why I use Vanguard Index funds. When will Vanguard rename their company, "You're an idiot, we aren't funds?"

  • Report this Comment On October 05, 2012, at 12:42 PM, cashforever wrote:

    The best education you can have is not relaying on formal education. People just don't have a strong enough heart to actually think independently and "beat" the system. People are probably weak enough to just say "yeah, I'm an idiot" and then not try to teach themselves. Bad choice!

  • Report this Comment On October 08, 2012, at 6:06 PM, OtterPater wrote:

    The problem with the test for an "accredited investor" (which is a defined term, as Bill noted) is that it purely an assets test, not a sophistication test, nor a test for whether an investment is appropriate for the recipient.

    The theory behind the definition (which only recently was modified to exclude your personal residence from the equation) is that if you are rich, you are smart, and if you are not smart, you are wealthy enough to have advisors help you. So, now the hedge fund (your newest best friend) is going to advise you, even if the investment isn't appropriate such as Bill's example of a retiree who qualifies but only because of retirement funds that may have to last 10, 15 years or longer.

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