I n the spring of 1998, market amateurs who had invested in a book titled The Beardstown Ladies' Common-Sense Investment Guide received some disillusioning news. The grandmotherly "Beardstown Ladies," the nom de publicity of the Beardstown Business and Professional Women's Investment Club, had inadvertently doctored their accounts.
In their 1995 best-seller, subtitled How We Beat the Stock Market-and How You Can, Too, they had reported an average annual return during the 1984–1993 decade of 23.4 percent, besting the 14.9 percent of the Standard & Poor's 500 Index.
But in 1998, an audit uncovered an embarrassment. The Beards town lady in charge of keeping the club's accounts had been adding monthly dues-$25 per member, monthly-into the ostensible profits. Subtracting the dues lowered the return for their first decade's efforts to 9.1 percent. This return, like that of most investors, trailed the S&P 500 average. After 1993, the Ladies' returns rose with the market. But over a 14-year period, their audited annual average was 15.3 percent, compared to 17.2 percent for the S&P 500. If not for their lecture fees and book royalties, they would have done just as well putting their money into a mutual fund and letting it sit there.
The Ladies' inflation of investors' expectations was innocent. But another instance of inflating investors' expect ations- this one not so innocent-was also reported in 1998. Three Maryland men were indicted for defrauding at least 130 investors in 17 states of $6 million over a period of five years. (The biggest loser was Tom Clancy, the best-selling thriller writer, who was reportedly taken for about $2 million.) Some "invested" their entire retirement accounts and then raised even more money to invest by borrowing on their credit cards. Part icipants were promised a 30 percent re turn on stock market investments, making pikers of the Beards town Ladies.
Great Expectations
Those taken in by the Beardstown Ladies and the Maryland fraudulent investment scheme suffered from a disability that public-opinion polls have shown to be widespread-investment illiteracy. Poll sters have found that a substantial percentage of Americans don't understand the commonplaces of financial news and don't know key facts regarding economics, finance, and the working of equity markets.
The danger of such illiteracy for people whose retirement would be scuttled by one ruinous investment was highlighted by Arthur Levitt, chairman of the Securities and Exchange Com mission. Speaking in May 1998 to the Investment Company Institute, an organization of mutual fund executives, he warned: "Financial illiteracy is very troubling in an era when workers are shouldering a significant portion of their retirement planning through 401(k) plans and IRAs. And financial illiteracy is downright frightening when you imagine a privatized Social Security system, in which workers' basic economic well-being could depend totally upon their own investment savvy."
Despite a lengthy stock market boom and the news coverage that feasts on it, the most widely reported polls-sponsored by news media-have asked few questions about financial matters that probed knowledge rather than attitudes. Most of the data that exist have been gathered for market research, sponsored by financial institutions studying how to corral customers. There has, however, been enough relevant polling to outline the extent of public ignorance.
A key bit of "irrational exuberance" revealed by these polls is the anticipated long-term return on stock market investments. Both the Beardstown Ladies and the Maryland swindlers promised exceptional "performance." So do mutual funds trolling for new customers. As Levitt noted: "I worry that the fund industry is building unrealistic expectations through performance hype. I read the ads. I see nothing but performance, performance, performance. Why not clearly outline the impact of expenses or the nature of risks?" Noting "long-term market returns of about 10 to 11 percent a year," he pointed out that "a recent survey found that mutual fund investors anticipate returns of more than 20 percent a year for the next decade."
Mr. Levitt did not identify the survey, but it may have been one reported by the New York Times in April 1997: "In a nationwide survey of 750 mutual fund investors conducted for Montgomery Asset Management, a San Francisco mutual fund company, respondents said they expected an average return of 16 percent this year [1997] on their mutual fund investments. Over the next 10 years they forecast an average annual return of 22 percent."
Levitt's concern was anticipated by the sponsor of the poll, quoted in the Times. "This is absolute folly," said R. Stephen Doyle, chairman of Montgomery Asset Management. "Those kinds of expectations could lead to some unhappy and distressing consequences."
But expectations continued to rise, along with the Dow Jones Industrial Average. In late summer of 1997, Mont gomery Asset Manage ment sponsored another poll. Another sample of 750 mutual fund investors anticipated a return of 22 percent in 1997 (up from the earlier forecast of 16 percent), and 34 percent for each of the next ten years. At that rate, their investments would more than quadruple within five years. At that moment, of course, history was still on their side. In 1997, the Stand ard & Poor's 500 index rose more than 33 percent, and it rose 30 percent in four of the ten years during the decade prior to 1998.
Expectations have been elevated by atypical experience. A substantial proportion of investors are newcomers to the financial marketplace and have never endured a prolonged drop (in contrast to short-lived dips or "corrections"). In the spring of 1997, the New York Times reported in its Mutual Funds Quarterly supplement that in 1995 and 1996 the number of Americans who owned shares in mutual funds grew by a third, to 63 million, meaning that "millions of neophyte fund investors have never experienced a bear market." A Washington Post–ABC News poll taken in October 1997 found that only 43 percent of all those questioned recalled what happened to the stock market on "Black Monday" of October 1987. Even among those polled who owned stocks, barely half-51 percent-could identify the event. And those who knew about it would have had their optimism reinforced by the aftermath; a recovered stock market climbed to new highs, a point endlessly reiterated by purveyors of the prevailing optimism.
Stratospheric expectations also marked the sophisticated lenders who bankrolled Long-Term Capital Management (LTCM), the ultimate "hedge fund," masterminded by Nobel laureates in economics. When "emerging markets" submerged in 1997 and 1998, a bubble sitting on a pyramid of loans burst. The investment stars of LTCM, who leveraged their investments with surreptitious borrowing on two cont inents, look as credulous in retrospect as the neo phytes who bankrolled their investments with credit card debt. In this instance, the Federal Reserve Board concluded that the fund should be rescued by a consortium of financial institutions. Insider hubris fared better than conventional ignorance.
Early last September, after Russia defaulted on its international debt but before the crash of LTCM was publicized, the Gallup organization conducted its quarterly investor-attitude survey for the investment firm Paine Webber. Near-term expectations of a climbing stock market had been somewhat dampened. Long-term expectations, however, substantially outdistanced the historical record. This was especially true for "new" investors-those in the market five years or less. Likely to be younger and poorer than "experienced" investors, the newcomers looked forward to average annual returns of 18 percent over the coming decade. (Compare this to the long-term return of 10 to 11 percent a year that SEC Com missioner Levitt thought realistic.) For 1999, they expected the average investor to garner 10.2 percent, but anticipated 15.2 percent for themselves. It's worth wondering to what extent these high-flying expectations fuel support for privatizing Social Security.
Asking poll respondents to state the return expected on investments produces an answer clearly revealing the distance between their hopes and history. But when a poll inquires about more complex aspects of investment and finance, the answer to a single question can mislead by masking respondents' lack of knowledge.
Researchers in "behavioral economics" know that alternative descriptions of the same basic choice can alter subjects' responses. Mutual fund investors polled for Montgomery Asset Management in 1997 were asked what they would do if, given that the Dow Jones Index was at 8,000, (1) it dropped 5 percent, or (2) it dropped 400 points. Twice as many respondents (30 percent vs. 15 percent) said they would be more likely to exit their fund, or at least stop investing further, because of a 400-point drop than because of a 5 percent drop. The same condition produced sharply divergent responses when described in two different ways, a com mon finding in similar experiments. Innum eracy is apparently a significant aspect of investor illiteracy.
What Investors Don't Know
As former Washington Post reporter Stanley Hinden makes clear in writing about his retirement, even seasoned investors sometimes need to learn a lot if they are to navigate successfully through today's turbulent financial seas.
Although I had been a financial writer, I quickly realized there were a lot of subjects I didn't know much about. . . . Ask yourself this question: "How much do I know about Social Security, Medicare, Medigap policies, Medicare HMOs, Medicaid, nursing home insurance, life insurance, annuities, mutual funds, asset allocation, diversification and the rules for taking money out of IRA accounts?"
What many claim to "know" is, often, not so. For example, a May 1997 Pew Research Center poll found that 40 percent of respondents claimed to know who Fed eral Reserve Chair man Alan Green span was (an unusually high percentage for a nonelected official). Responses to other polls over the years reveal that recognizing Greenspan's name is not the same as knowing what he does. The stock and bond markets rise and fall on speculation about whether the Federal Reserve is going to raise or lower "short-term" interest rates-yet most Americans don't know the Fed is responsible for the shifts. News media trumpet the most oblique comments of the Fed chairman, and financial analysts pore over his murkiest phrases as though they were sheep entrails. Yet a majority of Amer icans don't understand the Federal Reserve's role in the U.S. economy.
The gap between recognition and understanding was highlighted further by a national survey that Gallup conducted in 1992 for the National Center for Research in Economic Edu cation at the Uni versity of Nebraska. Only one-third of those questioned knew it was neither the president, nor Congress, nor the Treasury Department that set monetary policy, but the Federal Reserve. Still fewer-21 percent-could identify a change in the discount rate as an example of monetary policy.
The distinction between monetary and fiscal policy may seem a technical point, but such know ledge gaps indicate that much of the public doesn't know which public officials, elected or appointed, make the decisions that determine how the economy behaves. Mistaken attributions of responsibility determine elections; the president gets undeserved credit-and blame-for the performance of the national economy.
A substantial percentage of the general public does not understand terms commonly used when discussing finance and investments. In the spring of 1996, Roper poll interviewers presented respondents with a set of terms and asked them if they "have a pretty good idea of what the person is talking about, some idea, or not much of an idea of what that person is talking about." Re spondents did not have to prove their claims by demonstrating actual knowledge.
On the 15 items on the Roper list, the highest levels of claimed knowledge were for "depression" (76 percent had a "pretty good" idea of what that was), "inflation" (also 76 percent), and "recession" (72 percent). Fully one-quarter of those questioned, therefore, acknowledged they had no meaningful understanding of three basic terms of economic life.
The level of claimed knowledge for the other terms was even lower. Only 39 percent of respondents claimed a "pretty good" idea of the meaning of "capital gains tax"; and only 38 percent claimed a "pretty good" understanding of "investment capital." Sometimes, what people said they knew was called into question by the things they admitted they didn't know. For example, 42 percent said they had a "pretty good" idea of what the "Federal Reserve Bank" is-but only 28 percent claimed a "pretty good" understanding of "tight monetary policy," for which the Fed would be responsible.
One way to estimate the extent of investor illiteracy is to determine what experienced investors know or don't know. In early 1996, Princeton Survey Research conducted an "Investor Knowledge Survey" designed "to find out what the average American investor knows." The sample comprised only individuals who made their household's investment decisions. This was a distinctly above-average group: 51 percent had investments ranging from $20,000 to $150,000 or more; 68 percent had at least some college education; 75 percent had owned some form of investment for anywhere from 5 years to more than 25 years. Presumably, this was a sample of knowledgeable investors, whose responses should have provided a baseline of investment literacy.
The core of the survey was an eight-question test of investor knowledge. Some questions dealt with fundamentals; some were trickier. The authors of the study found that half (50 percent) of those polled correctly answered four to six questions. Another third (32 percent) answered from zero to three questions correctly. The authors of the study drew this dour conclusion: "Less than a fifth (18%) of investors surveyed are truly literate about financial matters specifically related to investing (i.e., correctly answered seven or eight questions)."
The question receiving the highest percentage of correct answers asked respondents to choose among definitions of a "blue-chip" stock: "Is it a stock offered by a high-tech company, the stock of an established company with a history of paying dividends, or a low-priced security usually trading for less than a dollar a share?" Two-thirds (66 percent) answered correctly- that it was an established company's stock. But 20 percent said they didn't know, and the remaining 14 percent divided evenly between answering that a blue chip was the stock of a high-tech company or a dollar stock. The youngest investors, those 18 to 29, were most likely to answer this question incorrectly: besides the 22 percent who gave a "don't know" answer, 14 percent thought a blue chip was a high-tech stock, and 17 percent thought it was a dollar stock. Young investors are more ignorant as well as more optimistic.
The question receiving the second highest percentage of correct responses asked respondents which investment had produced the highest return during the previous 30 years-stocks, bonds, savings accounts, or certificates of deposit. Almost two-thirds correctly answered stocks. But 14 percent answered certificates of deposit, 9 percent answered bonds, and 11 percent didn't venture an answer at all. (Keep in mind that the erring respondents are actual investors.)
The percentage of correct answers dropped sharply when respondents were asked the relationship between the rise and fall of interest rates and the rise and fall of bond prices. Although the direction of interest rates and the effect on bond prices is frequently reported in business-news pages, only 39 percent of respondents knew that bond prices decline when interest rates rise. In no subgroup of respondents did more than 50 percent answer this question correctly (exactly half the college graduates got it right). Only 42 percent of bondholders gave the right answer.
Mutual funds are the entry point into equity investing for most novices. As more and more people have wanted to get in on the raging bull market, mutual funds have proliferated. Yet a majority of investors are ignorant of the costs built into ownership of mutual fund shares. The Investor Know ledge Survey also asked whether the following statement is true or false: "A 'no-load' fund involves no sales charges or other fees." Virtually as many mistakenly said there were no fees (36 percent) as answered correctly there were fees (38 percent)-and 26 percent answered "don't know." More than half of those surveyed, in other words, didn't know that mutual fund ownership has a cost attached.
Among those who owned mutual fund shares, a larger minority answered correctly: 45 percent recognized they pay fees. Still, more than half of the mutual share owners were unaware they paid fees, with 37 percent answering incorrectly, and 18 percent saying they didn't know. "No load" is in effect a wildly successful promotional label; it masks the fees that compensate managers of every mutual fund. "Do you really expect investors to understand the alphabet soup of A, B, C, D, I, Y, and Z shares?" SEC Commissioner Levitt asked the group of mutual fund executives he addressed last May. "To figure out what combination of front-end loads, CDSLs, 12b-1 charges, commissions, and who knows what else they're paying? . . . I don't have to tell this audience-a 1 percent fee will reduce an ending account balance by 17 percent on an investment held for 20 years."
Wiping out illiteracy of any kind requires appropriate educational materials. The essence of consumer literacy, of which investor literacy is a subdivision, is appropriate and easily understood labeling. Truth-in-lending statutes effectively promoted borrower literacy by requiring the posting of a standardized interest rate, so rates charged by different lenders could be compared. Grocery shoppers can take a can off the shelf and learn how much of the content is fat; unsophisticated investors should be able to scan a mutual fund's newspaper ad or prospectus and discern easily how much of the return is deducted for fees and other charges.
Since Asian stock markets imploded and LTCM went on life support, the upper reaches of the financial world have been concerned with promoting "transparency" in overseas accounting practices and hedge fund portfolios. After derivatives are made transparent for "boutique" investors, perhaps "supermarket" investments such as mutual funds-not to mention the risks and costs of privatizing Social Security-will be made more transparent for the rest of us.
