Experts Are at a Loss on Investing
Harry M. Markowitz won the Nobel Prize in economics as the father of “modern portfolio theory,” the idea that people shouldn’t put all of their eggs in one basket, but should diversify their investments.
However, when it came to his own retirement investments, Markowitz practiced only a rudimentary version of what he preached. He split most of his money down the middle, put half in a stock fund and the other half in a conservative, low-interest investment.
“In retrospect, it would have been better to have been more in stocks when I was younger,” the 77-year-old economist acknowledged.
At least Markowitz invested more wisely than some of his fellow Nobelists. Several of them concede that they have significant portions of their nest eggs in money market accounts, some of the lowest-returning investment vehicles available.
“I know it’s utterly stupid,” confessed George A. Akerlof, a UC Berkeley professor and 2001 winner of the Nobel Prize in economics.
As President Bush crisscrosses the country promoting his plan to overhaul Social Security, he argues that Americans are ready to trade in a portion of their traditional benefits for ownership and control over their own investment accounts. People have grown so comfortable with stocks and bonds, he asserts, that they can invest their way to more prosperous retirements by watching their quarterly statements, adjusting their portfolios and looking out for themselves.
But a growing body of research shows that millions of Americans fail to get even the most elementary investment decisions right.
More than one-quarter of those eligible for employer-provided 401(k)s fail to sign up for them, according to the Federal Reserve. More than half of those who do sign up funnel their money either into overly conservative or overly aggressive investments, according to the Employee Benefit Research Institute, a Washington think tank sponsored by hundreds of companies.
Even more disconcerting, new research suggests that most people don’t behave anything like the economically savvy men and women that free-market advocates and economic theorists claim they are. They often shut down in the face of many choices. They sometimes even fail to go after free money.
In committing investment errors such as these, ordinary Americans turn out to be in good company. Even some winners of the Nobel Prize in economics admit to making similar mistakes, either by failing to pay attention to their own retirement arrangements or by making faulty decisions when they do.
“I think very little about my retirement savings, because I know that thinking could make me poorer or more miserable or both,” quipped 2002 Nobel Prize winner Daniel Kahneman of Princeton University.
“I would rather spend my time enjoying my income than bothering about investments,” said Clive W.J. Granger, an emeritus professor at UC San Diego and a 2003 Nobel Prize winner.
White House officials dismiss such remarks as largely irrelevant to the Social Security debate. They describe the president’s proposed investment accounts as voluntary and low-risk.
They suggest that those who oppose the accounts are taking a special swipe at low-income Americans, who otherwise would not have the money to invest on their own.
“It’s almost an insult to the ability of some Americans to take charge of their retirements,” Bush spokesman Trent Duffy said.
That Nobelists and other highly educated professionals get tripped up by retirement is hardly proof that people can’t handle their own retirement investments. But it does suggest that few are terribly good at the job, and fewer have the time or inclination to get better quickly.
And the president’s accounts plan would require people to do a very good job at investing.
Under the proposal, Americans born in 1950 and after would be able to divert a portion of their Social Security payroll taxes into individual investment accounts. But in return for doing so, their traditional Social Security benefit would be reduced -- by the amount diverted plus a 3% annual after-inflation charge on that amount.
With inflation now running about 3%, that means account holders might have to earn 6% a year just to break even. Anyone who followed Markowitz’s approach -- putting half of their balance in a low-interest investment -- would almost certainly lose money by signing up for accounts. So would someone who followed Akerlof’s approach -- placing a substantial amount of it in money market accounts, which now pay about 2%.
Markowitz, Akerlof, Kahneman and Granger are not the exceptions among the nation’s most-educated elite or the general population in taking a cautious or hands-off approach to retirement investment.
In interviews and e-mails, five of the 11 Nobel winners in economics during this decade and a handful of others since 1990 said they failed to regularly manage their retirement savings. One even says he missed the mark in how he invested his prize winnings.
Several had or have retirement funds parked in money market accounts or other low-interest investments that they say are probably too conservative.
The same is true of an estimated 50% of Harvard’s 15,000-member faculty and staff, who permit all of their retirement savings to be funneled into money market accounts, according to the university, by failing to specify how they want their funds invested.
The forget-about-it approach also applies to most of the 3.2 million members of TIAA-CREF, or Teachers Insurance and Annuity Assn.-College Retirement Equities Fund. TIAA-CREF oversees retirement investments for most of the nation’s college professors and research scientists. Almost three-quarters fail to make a single adjustment in their retirement accounts during the course of their careers, despite repeated urgings by experts that people change their mix of investments as they age.
“If the creme de la creme of the economics profession and American academia can’t get these sorts of things right, why should we expect everyone else to?” asked Yale finance theorist Robert J. Shiller. “Why should we be surprised that people who already carry a heavy burden paying their bills and keeping up with their 401(k)s, if they have them, are reluctant to take on new responsibilities with these [Social Security] accounts?”
Part of the problem is that retirement investment is one of the most difficult financial tasks Americans undertake -- far more difficult than financing a house or paying for college because it involves so many imponderables so far in the future.
“Retirement is not like buying a cup of coffee,” said Joseph E. Stiglitz, a 2001 Nobel Prize winner, former Clinton administration economist and Columbia professor. “It’s not something you get to do over and over again and learn from your mistakes.”
Recent research suggests that people, by nature, often make poor economic decisions.
Analysts examining the actual behavior of individuals -- as opposed to what most economists’ theories predict -- find that it rarely conforms to standard notions of what’s rational. Instead, it often involves systematic mistakes that end up producing the very opposite of what people say they intend.
Consider, for example, the matter of choice. Polls find that by wide margins, Americans favor the idea of having choices.
But research on 401(k) plans by Columbia’s Sheena S. Iyengar and others shows that, as the number of account choices that people are offered goes up, the number of choices that people make goes down -- about 2% for every 10 additional accounts.
“People say they want more choice, but when they’re given it, they get overwhelmed and use it as a reason to opt out of deciding,” Iyengar said.
Or consider economic self-interest. Analysts have long wondered why so many people fail to take advantage of their employers’ offers to match their 401(k) contributions. The reason often cited by those who don’t participate is that they don’t want to risk having to pay government-imposed tax penalties should they need to get at their money quickly.
But when David Laibson of Harvard, Brigitte Madrian of the University of Pennsylvania and a colleague studied working people who had reached the age when the penalties no longer applied, they discovered that 40% still failed to take the match.
“It’s astounding. These people are doing the economic equivalent of leaving $100 bills on the sidewalk,” said Laibson. The implication, he said, is that “just because people have the economic self-interest to do something and just because they are given a substantial incentive to do it doesn’t mean they’re going to do it, or do it correctly.”
Not even if they’re highly educated, not even if they’re Nobelists.
Edward C. Prescott of Arizona State University shared the Nobel Prize last year for, among other things, writing about how central bank policymakers lose credibility when they switch directions too often. But he acknowledged that he and his family had been caught up in the switching game as they had tried to ride the hottest investment trends.
“There was a little time there in the ‘90s when my wife was gambling on stocks,” he said. More recently, he made an investment purchase of a house in Phoenix to see if he could ride the real estate boom.
Akerlof, the Berkeley professor who shared the 2001 Nobel with Stiglitz and Stanford economist A. Michael Spence, won for a paper on the economics of used cars called “A Market for Lemons.” But he confessed that he had a substantial chunk of his retirement savings in a lemon of an investment -- a money market account.
He said he placed the funds there because he couldn’t decide what to do with them.
Douglass C. North, an economist at Washington University in St. Louis, won the Nobel Prize in 1993 for work on the importance of institutions in fostering growth. However, in deciding how to invest his prize money, he trusted his gut rather than institutions. He concluded that the stock market had peaked, and poured the money into low-interest municipal bonds. When stocks confounded his predictions by doubling in value, he said, “my wife spent years berating me.”
Still, he hung onto the bonds, and stock prices eventually reversed course. Chief among the rewards he said he collected: “My wife quit berating me.”
The financial shortcomings of the Nobelists and the more fundamental problem of faculty members and retirement plan members failing to make any investment decisions increasingly trouble officials at places like Harvard and TIAA-CREF.
These officials wonder whether those for whom they are responsible -- and, more generally, Americans -- can properly handle the retirement investment responsibilities they already have, much less new ones.
“Most people don’t want to deal with savings and asset allocation,” said Edward Moslander, TIAA-CREF’s director of pension product management. “There is an element of self-realization here; they’re saying, ‘This isn’t what I know. This isn’t what I do.’ ”
TIAA-CREF and other giants like Fidelity Investments and the Vanguard Group have responded to evidence of people’s faulty financial decision making -- and the refusal of many to make any decisions at all -- by rolling out accounts that make most decisions for investors.
The response has been striking; assets in Fidelity’s so-called “life cycle” funds have jumped from $6.6 billion to $33.6 billion in four years, according to the company. As an investor gets closer to retirement, these funds shift holdings from stocks into bonds to shield the investor from sudden stock market shifts.
A number of safety features would be built into the president’s Social Security accounts, the White House said. Account holders would be allowed to invest in only a handful of conservative stock and bond funds. When they reached age 47, they automatically would be switched into a lower-risk life-cycle fund. In addition, when most people retired, they would have to buy an annuity that promised a steady stream of monthly payments. They would not be able to withdraw the money as a lump sum.
The inclusion of these protections points to a dilemma for Bush in making the case for accounts: Most Americans recognize the dangers the protections are intended to shield against.
For some, it is a powerful argument for keeping Social Security what it is today, a safety net, rather than converting the program into an individual investment vehicle.
“We have a lot of people out there with 401(k)s who have never managed an investment in their lives and are just trying to keep themselves from drowning,” said William F. Sharpe, a Stanford finance professor emeritus who shared the 1990 Nobel with Markowitz and Merton H. Miller and founded a company that offers to make people’s retirement choices for them.
“I suspect if you asked them, they’d say: ‘I’ve got enough trouble; I don’t want to screw up my Social Security.’ ”