Posted by on Mar 13, 2017 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  March 10, 2017 9:47 am ET

As far as most investors are concerned, the standard warning in prospectuses — “past performance does not guarantee future results” — might as well read “Wjxsndf omv gyjrhubji qmta gjq ek blgy zbq oynru.”

A new initiative at the Securities and Exchange Commission could be one small step in the right direction. On March 10, the SEC is holding its first “evidence summit” on how to simplify and clarify financial disclosures.

“The SEC does a good job of providing disclosure of all the information that the most sophisticated investors would find useful,” says Rick Fleming, the agency’s investor advocate. “But with this new program we’re looking to do a better job of making disclosure more useful to the average person.”

Financial disclosures need more than a tweaking. “The idea that you can just give people some paper and change their behavior is absurd,” says George Loewenstein, a behavioral economist at Carnegie Mellon University.

Millions of Americans get heaps of prospectuses, proxy statements and periodic financial reports for mutual funds and other investments every year. In a world of multisensory, electronic information, these dead-tree documents still arrive by snail mail, dozens of impenetrable pages that can only be described as chloroform in print.

And, for all their detail, these disclosures don’t even inform the people who receive them.

recent survey of 750 wealthy investors by Natixis Global Asset Management found that 71% believe that index funds are “less risky” than other investments.

However, nearly all index funds are designed to be as risky as the markets they invest in. If the S&P 500 goes down 30% in a year, for instance, an S&P 500 index fund charging 0.1% in annual expenses will lose 30.1%.

In a study just published in the Journal of Behavioral Finance, graduate business students chose among four index funds identical in all respects except fees. Students who didn’t review standard SEC disclosures about the importance of minimizing fees put an average of 50% of their money into the more-expensive funds. Those who got the information about fees still put a wealth-wasting 47% into the higher-cost portfolios.

“We thought the disclosure would mitigate the problem,” says co-author Nathan Mauck, a finance professor at the University of Missouri-Kansas City, “but it didn’t.”

People are not stupid. What they are is busy and lazy. Pressed for time, with countless stimuli tugging at our attention, not many of us want to bother spending hours, days or weeks focusing on a decision — no matter how much is at stake.

Many experiments have shown that the harder a risk is to understand, the less it will seem likely to occur. Paradoxically, then, financial documents that discuss every conceivable risk in highly technical detail may end up making the investment seem safer.

What can be done?

Moving away from paper to interactive, online displays would create “a format that is comparable and consistent across investments,” says Eric Johnson, a professor at Columbia Business School who studies consumer decision-making. Instead of reading that your fund charges 1.13% in annual expenses, for instance, you could see 1.13% placed on a spectrum from the cheapest fund in its category to the most expensive.

Daniel Goldstein and Jake Hofman are behavioral scientists at Microsoft Research, a unit of the computer giant. They have shown that numbers become much easier to grasp — and remember — when the words “to put this in perspective” are coupled with a familiar reference.

Today’s prospectuses show cumulative fees on a $10,000 investment over one, three, five and 10 years. Instead, an investor should be able to see those fee totals for any amount or time period she chooses.

If stocks gained an average of 6% annually over the next 30 years, someone who invested $25,000 and paid a 1% yearly fee would cumulatively forgo more than $35,500 in gains. “To put this in perspective,” the disclosure might say, “that difference is greater than the amount you started with.”

Simulations — video-game-like displays animating the range of outcomes based on past experience — could convey risk and return more memorably than words or numbers can do.

Ultimately, disclosures could become “more like a teaching tool,” says Prof. Loewenstein of Carnegie Mellon. “People could be given the information and then be asked questions about it online so it becomes clear what they do and don’t know.”

The SEC says it could start testing some ideas like these in the next few months. It can’t happen soon enough.

Source: The Wall Street Journal,

For further reading:

George Loewenstein, Cass R. Sunstein, and Russell Golman, “Disclosure: Psychology Changes Everything

George Loewenstein’s other articles on the psychology of conflicts of interest

Dan Goldstein’s research

James J. Choi, David Laibson, and Brigitte C. Madrian, “Why Does the Law of One Price Fail? An Experiment on Index Funds

James D. Cox and John W. Payne, “Mutual Fund Expense Disclosures: A Behavioral Perspective

Lauren E. Willis, “The Consumer Financial Protection Bureau and the Quest for Consumer Comprehension

The Big Corruption in Small Gifts

Definitions of ANNUAL REPORT, DISCLOSURE and PROSPECTUS in The Devil’s Financial Dictionary