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investing for dummies

SEC Study Proves That Stock-Picking Should Probably Be Left to the Professionals

Let's see, stock. S-T-O-C-K. Hmm. Can you use it in a sentence?

Just in time for your Labor Day vacation, the Securities and Exchange Commission has produced a spellbinding story of what happens when normal people try to invest like Wall Street big shots.

The masterpiece in question is "Study Regarding Financial Literacy Among Investors" [PDF], which was commissioned by the watchdog agency in response to a Dodd-Frank mandate. And while a 182-page treatise on financial literacy may not seem like beach-read material, it's very likely the most darkly funny thing you'll read all year.

The basic story is that after the financial crisis, lawmakers decided that one of the reasons the economy collapsed is that average investors didn't understand the various stocks and bonds and mutual fund shares they had bought. So they decided to require the SEC to find out how much average (also known as "retail") investors knew about the stuff in their portfolios, by asking them questions like, and I'm paraphrasing: "This stock you own — what does it do?"

The resulting study, released today, is amazing and depressing. Not only does it contain the world's longest section titles ("The Most Useful and Understandable Relevant Information that Retail Investors Need to Make Informed Financial Decisions before Engaging a Financial Intermediary or Purchasing an Investment Product or Service") but it sheds light on how little people know about the financial products they own.

The SEC's conclusion is fairly straightforward: "U.S. retail investors lack basic financial literacy ... have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud."

Yikes! Okay, so how did it find that out? Well, the agency gave 5,000 retail investors an online quiz in which they were asked to look at summary documents for a made-up mutual fund, then answer questions about how well they understood what they'd read. (In a nod to the earthy nature of retail investing, the imaginary funds were named "Petunia Core Equity," "Gardenia Asset Allocation Portfolio," and "Hydrangea Bush Government Bond Fund." I am not making this up.)

The results were about as dismal as you'd expect: "Many of the online survey respondents on the Brochure panel who claimed to understand fee and compensation disclosure in the Brochure, in fact, did not." 

For instance, they had difficulty calculating hourly fees and fees based on the value of their assets under management. They also had difficulty answering comprehension questions about investment adviser compensation involving the purchase of a mutual fund and identifying and computing different layers of fees based on the amount of assets under management.  Moreover, many of the online survey respondents on the point-of-sale panel had similar difficulties identifying and understanding fee and compensation information described in a hypothetical point-of-sale disclosure and account statement that would be provided to them by broker-dealers.

And then there are results like this, which reveal that even when retail investors read a financial document, their ability to understand said document is pretty limited: "[M]any of the online survey respondents who reviewed the Gardenia Summary Prospectus agreed that it highlighted important information (72.4%) and was well organized (71.0%), while fewer of them reported that it was written in a language that they understood (50.4%), was clear and concise (49.9%), and was user friendly (48.9%)."

What's the thought process there? Boy, that mutual fund document sure looks pretty. Nice font, good wide margins. Probably contains some stuff I should know. But actually sit down and read the thing? Pshh. Okay, Poindexter. Sure. I'll get right on that.

The SEC then convened a focus group, in which retail investors went all therapist's couch on them, and told them that not understanding the stuff they invested in made them sad:

One focus group participant from a focus group consisting of users of broker-dealer services elaborated that, “[i]f I were fixing up my house, I’d get three proposals and I’d review every single line of the contract, front and back and everything else before I’d let him in my house.  But when it comes to this, I just don’t get it.  I don’t know if that’s a failing with me, at least in part it is.  Or a failing with just that it’s not transparent or just complex.”

To be fair to retail investors, I've seen some pretty terrible mutual fund documents in my day, and I probably wouldn't understand every line of the prospectus for the Weeping Willow Total Return Bond Fund or whatever. But for exactly that reason, I leave the management of my (unimaginably tiny) investment portfolio to people who do know how to read the fine print.

It's been common knowledge for years that with all the inherent advantages Wall Street traders have over their retail brethren, it's basically impossible for the retail crowd to beat the market on any consistent basis.

And now, with the SEC's study proving in dramatic and depressing fashion what everyone already knew, it's about time for regulators to step in and force retail investors to close their eTrade accounts, step away from CNBC, put all their money in passive index funds, and go mow the lawn instead.

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