A High IQ Won't Make You a Great Investor

You'd think that being blessed with great intelligence would be a good thing, wouldn't you? After all, it can get you into good schools, get you accolades and good jobs, and can make life seem richer (such as when you find out what the next number in pi is, or when you catch typos in a newspaper).

But I just read about a study that found something alarming: Researchers at Yale and Harvard looked into why many investors invest in index funds with higher fees rather than other available funds. And the kicker is this: Their subjects were all of above-average intelligence, being educated Harvard staffers, Wharton MBA students, or Harvard students. The students had average SAT scores in the 98th and 99th percentiles.

The researchers found that when these folks were presented with four index funds and asked to distribute $10,000 among them optimally, they usually did not focus on the lowest-fee fund.

Apples and apples
That's puzzling, because S&P 500 index funds are almost like commodities. Each should be invested in the same 500 companies, in pretty much the same proportion. You're not paying for any manager to make buy-and-sell decisions. Last time I checked, these were the top seven holdings of a standard S&P 500 fund -- in this case, the Vanguard S&P 500 Index (VFINX):

Data: Morningstar.com, Motley Fool CAPS. Percentages as of Sept. 30.

Interestingly, even with 500 stocks in the index, the top 10 holdings make up almost 20% of the fund's value. Check out other S&P 500 index funds and you should see the same seven top holdings in roughly the same proportions, as long as the date they're measuring from is the same. Given that, check out the following range of fees for some such index funds that I found at Morningstar.com:

Data: Morningstar.com.

What's going on
The table above should shock you a little. If you invest $10,000 in one such fund, you could pay anywhere from $10 for the year in fees to $79. And you might end up paying a sales charge of up to $525 upfront. So why would smart people choose funds with higher fees, when funds with lower fees are available? Well, the researchers found that "Subjects overwhelmingly fail to minimize fees. ... Instead, subjects place high weight on annualized returns since inception."

In other words, we investors, even us smarties, often place more importance on how we think a fund performs than on its fees. To some degree that can make sense when we look at managed funds, where fund managers are actually using their brains and making trading decisions. But with index funds, it doesn't make much sense.

You might wonder, though, how they're finding different performance numbers to respond to, since they're all invested similarly. The key there is in the "returns since inception." For example, if Fund A was created just before a big bull market, and Fund B was created just before a bear market, they will have different returns since inception. So investors are often responding to an almost random figure -- one largely simply reflecting when a fund was created.

It's sad, really. We investors are always on the lookout for the most promising stocks to buy, so that we can make our portfolios grow quickly. Yet we shortchange ourselves by making silly mistakes, focusing on the wrong things. The study's researchers offered this sobering fact: "In 2007, retail S&P 500 index fund investors paid $206 million more in expenses (excluding sales loads) than they would have if their entire S&P 500 index fund balance were in the retail no-load S&P 500 index fund with the lowest expense ratio." Ouch.

So be careful out there. Take fund fees seriously, and know that most index funds should be very similar.

Here are articles that can help you avoid other mistakes:

• How You Can Get Rich With 4 Dumb Mistakes
• 3 Reasons You're Being Set Up to Fail
• Want to Get Rich and Stay Rich?