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You're an Idiot. Statistically Speaking.

By Motley Fool Asset Management - Updated Oct 31, 2016 at 4:54PM

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A change in how hedge funds are marketed is in the works.

The following commentary was originally posted on, 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 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, 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.

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