Choice management | Harvard Gazette

The result while shocking may be due to misunderstanding: people just carry their everyday experience over to the study. In real life, past returns are more important than fees. 

Given a choice of mutual funds that differed only by brand name and fees, less than 10% of people in an experiment did the “rational” thing and chose the funds with the lowest fees—even though the funds offered the same returns, say Brigitte Madrian and David Laibson of Harvard and James Choi of Yale. Investors’ apparent inability to understand about fees could have a serious impact on their nest eggs: A single additional percentage point in fees translates to balances that are 20% smaller over a lifetime of investing.

In a paper published last year, Madrian and Laibson argued that employers should strive to “design institutions that facilitate good choices, rather than assuming that giving people every option under the sun will lead to the right decision.”

My belief now is that if you give people bad options, even if you explain the characteristics that make them bad, many people will still choose those options.

Participants in the study were asked to allocate $10,000 across four S&P 500 index funds, and were paid according to how their investments performed. For most people, Laibson said, investments are based on two considerations — how funds perform and the suite of services offered by an investment company. In this study, however, researchers were able to eliminate both, the first because index funds — designed to replicate an index set by the S&P — perform nearly identically, the second because the funds were administered by the researchers.

“Once you eliminate those two considerations all that’s left is what we wanted to focus on, and that’s fees,” Laibson said. “Given this experimental design, the ‘right’ answer is unambiguous; it’s the fund with the lowest fees.

“What we found is that the participants were, in essence, oblivious to fees,” Laibson continued. “A tiny fraction, less than 10 percent, did the thing that economists would say is the rational thing and put all the money in the lowest-fee fund. By comparison, the average fee that our participants paid was on par with — and in some participant populations well above — the fee they would have paid had they just thrown darts. Basically, they chased historical returns, they chased brand, and they ended up going for the funds that, by and large, had the highest fees.”

A variety of populations took part in the study, including Harvard staff members, Harvard undergrads, and students at the Wharton School of the University of Pennsylvania. Each time, Laibson said, the results were the same.

Said Madrian: “This research shows that individuals aren’t using the right types of information in making mutual fund investment decisions. They place too much weight on past returns, and too little weight on potentially important factors like fees.”

via Choice management | Harvard Gazette.

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