Why Is Investing So Complicated?

Jul 13, 2015
Behavioral Finance, Question of the Day, Investing, Mutual Funds, Advertising, Current Events, Article

One of the top NY Times articles columns this weekend came from a Harvard economics professor and was titled “Why Investing Is So Complicated And How To Make It Simpler.”  This will be great article for your students to read to become more familiar with investing terminology and understand why so many are flustered by the thought of making investment choices. As the professor notes at the conclusion of the article, throwing one’s hands up and not doing anything isn’t a good option either so best to develop a strategy.

Here were the main complicating factors cited:

  • Too many choices:  Over 20,000 mutual funds and hundreds of ETFs to choose from not to mention thousands of individual stocks.
  • Can’t judge the quality of our choices until years into the future:  “Once I’ve used a phone for a few weeks, I can tell whether it was worth the money. By contrast, I may not know for decades (if ever) whether an investment was wise or foolish.”
  • Markets cater to our investment biases:

“For example, many consumers choose a mutual fund by looking at last year’s returns, despite warnings that they should not do so. This creates a winner-take-all situation with the highest-performing funds getting most of the investors. You might think this encourages funds to produce higher returns, and that might seem to be a good thing. But what it actually produces is a perverse incentive for fund companies to take risks. That’s because investors often choose what to do with their money once, and leave it there for a long time. Faced with that reality, the most profitable strategy for a mutual fund company can be to simply take risks in the hope of gaining high short-term returns.”

  • Many of us seek financial advice..but too often that advice is compromised:

“In one study that I conducted with the economists Markus Noth at Hamburg University and Antoinette Schoar at M.I.T., we tried to quantify the quality of advice on the market. We did this by sending mystery shoppers to financial advisers. Our shoppers received very bad advice, by any measure. They were told to put their money into highly nondiversified portfolios that were also expensive. That’s the worst of both worlds: high risk and low returns. Perhaps most shocking was when our shoppers started with portfolios that were well diversified and inexpensive. Even in those cases, they were told to switch to options that were clearly worse.”

So, now that we know how complicated it is, how about solutions?

  • Timely reminders and a few good default options help: “People in well-designed experimental programs who are given sound advice and plenty of reminders tend to save more.”
  • Ultimately, the columnist chose to invest in a target retirement account that had two characteristics: “As a result, I was careful to verify a few things about the fund I chose. First, I made sure that the stocks held by the fund were contained in a simple, broad-based index such as the Standard & Poor’s 500-stock index or the Russell 2000. Second, I verified that the costs were very low: The annual fees came to less than 0.2 percent. If the fees aren’t obvious, or if they are much higher than this, watch out.”

Encourage your students to read the comments section too, particularly those rated most highly by readers to see what pearls of wisdom they can glean there.

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.