Think You're a Savvy Investor? Better Read This

Last Updated Jul 2, 2010 3:43 PM EDT

"The more I learn, the more I learn how little I know."

- Socrates

Two great articles recently focused on the flip side of Socrates' universal truth. The New York Times' Errol Morris and the New Yorker's James Surowiecki both recently took a look at what's known as the Dunning-Kruger effect. (Surowiecki's piece, which focused on financial illiteracy, is well-worth investors' time.) Psychologist David Dunning and his graduate student Justin Kruger summarize it as follows:
... when people are incompetent in the strategies they adopt to achieve success and satisfaction, they suffer a dual burden: Not only do they reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the ability to realize it ... [Thus] they are left with the mistaken impression that they are doing just fine.
As Dunning told Morris, "If you're incompetent, you can't really know that you're incompetent," because your knowledge base isn't sufficient to tell you that you're failing.

You don't need to know much about the mutual fund industry to know that the Dunning-Kruger effect is alive and well in the field of personal investing, a fact that many mutual fund managers exploit to their benefit.

If you're reading an article like this on a site like Moneywatch, you're likely in the (hopefully growing) minority of mutual fund investors who, like Socrates, are able to acknowledge the fact that they don't know everything. The more you learn about investing, the more questions you develop: What are long/short equity funds, for instance? Do I need one? If so, how much? And which one?

Those are the sorts of questions that knowledgeable investors are eternally wrestling with. But at the same time, those investors are able to combine their base level of knowledge with their appreciation for the unknowns, separate what's really important from what is not, and put together and monitor a portfolio that will help them reach their long-term goals.

But the majority of mutual fund investors do not fit that profile. Instead, they're incompetent, and dangerously unaware of it. They know very little about investing, and are incapable of quantifying just how harmful and counterproductive their incompetence is. Many can't describe their approach, let alone determine how to measure its effectiveness.

This was driven home recently by a story a friend of mine related. His in-laws told him that a couple they were good friends with had been told by their advisor to liquidate all of their assets -- mutual funds, ETFs, savings accounts, everything -- and hold only cash in a safe in their basement.

Upon hearing of this advice, my friend's in-laws were understandably alarmed: should they do the same thing? After all, they had been told, their friends' advisor had served them quite well over the years, and had made them quite a bit of money.

It turns out that the advisor was a newsletter salesman, selling his advice in a monthly newsletter that the couple subscribed to for some $500 annually. Since its inception in 1980, the advisor's oldest newsletter had earned 8.3 percent annually, a rate that would have grown a $10,000 initial investment to $105,000 nearly 30 years later. Not bad, and surely the source of the couple's belief that they had made a lot of money by following his recommendations.

Unfortunately, the couple was apparently incapable of comparing that result to a reasonable alternative. If they had done so, they would have discovered that the total stock market had returned 10.9 percent annually in that same period, which would have grown that $10,000 investment to $212,000.

Their incompetence -- reflected in their inability to appraise the true value of the advice they were receiving -- resulted in a nest egg that was less than half what it might have been.

This isn't meant to denigrate the overall intelligence of these investors, nor that of the millions like them who are similarly victimized by poor decisions and advice. They simply suffer from the lack of financial literacy that, as Surowiecki noted, is rampant.

Unfortunately, far too many members of the mutual fund industry are less concerned with increasing the level of their clientele's knowledge than catering to the poor decision-making that illiteracy engenders. Complicated and expensive strategies are sold as sophisticated, far more worthy of investors' faith than a middlebrow approach of accepting the stock or bond market's return via an index fund.

Of course, the people pitching such sophistication are financially literate enough to know that the odds of their long-term success are quite slim. And over time, many of their clients will eventually learn enough to realize that they were sold a bill of goods. Unfortunately, such an education is accompanied by a rather large tuition bill.

  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.