If you get confused about choosing a mutual fund for your investment portfolio or 401k plan, there may be a reason. It’s because the companies intentionally make the process of selecting a mutual fund more complicated.
At least, that’s the hypothesis from MIT Professor Gustavo Manso, who said “financial services firms over complicate their products to maximize profits; the more they confuse investors, the more money they make.” So their profits aren’t tied to funds with the best stock picks, but rather funds that generate the most fees.
This intentional effort to make financial products — including mutual funds, insurance policies, credit cards and home mortgages — difficult for the average investor to understand was one main reason for the current economic crisis. Manso said there is a definite connection between the fine print in the documents accompanying increasingly more complex financial products and the individual default rate and the record breaking amounts of personal debt.
There is also the problem of too much choice. After all, who wants to make a selection from the 8,029 mutual funds and 21,631 different share classes that were available in 2007? Manso said that too many choices only paralyzes investors. “It remains unclear whether having access to more options leads to better decisions, as participants often make suboptimal choices in the face of too much information.”
This view was echoed by Annamaria Lusardi, professor of economics at Dartmouth College, who noted that people “get fatigued looking at all the financial options available to them.”
The fund companies confuse the situation by creating new types of fees or changing managers. These unanticipated changes may make it more difficult for the average investor to understand what is actually happening at the fund.
Similarly, when a 401(k) sponsor or the government suggests a default fund, it reduces the interaction among participants, who commonly seek each other’s advice about which funds to choose. Manso, and fellow researcher Bruce Ian Carlin of UCLA’s Anderson School of Management, said that creating a mandatory fund option would limit the “social learning” which occurs between more and less sophisticated co-workers. Eliminating social learning would harm the entire learning process.
How Investors Can Combat the Confusion
While fund companies may be intentionally trying to make a complicated situation more complex, investors can avoid the noise by doing the following:
Decide on an investment strategy before you choose funds. Since there are many funds to choose from and many of them are not significantly different from one another, investors have to examine the funds which fit into their strategy. This will narrow down the choices. A critical examination of the cost and performance data, manager stability and ownership, and fund company reputation should focus the research. Avoid the bling and advertising hype, especially about the funds’ star-rankings over the past few quarters. Short-term rankings do not prove anything.
Avoid owning too many funds. Undisciplined investors tend to own too many funds. A portfolio is a collection of individual mutual funds and stocks, not a seemingly random assortment. Do not chase performance. For example, precious metals funds do not belong in all portfolios, regardless of the advertising claims. If anything, the portfolio can borrow key concepts from military strategy which seeks to maximize the main effort, while holding assets in reserve. Scattering assets detracts from the main strategy. Using a core-satellite strategy, a model portfolio would have an equity and bond core positions, and 2-3 satellites for each core fund.
It’s OK to own boring funds. Many people fail to note the difference between trading and investing, which are dramatically different processes for very different types of people. Know which one you are; that will be a great place to start the simplification process.
