INTRODUCTION I. THE REGULATORY ENVIRONMENT FOR MUTUAL FUNDS AND 401(K) PLANS A. Mutual Funds B. 401(k) Plans II. THE LITERATURE ON INVESTOR DECISIONMAKING A. Cost-Sensitive Investing B. Diversification C. Proposed Mechanisms and Proposed Solutions for Investor Mistakes III. OUR EXPERIMENT A. Study Design B. Subjects C. Experimental Manipulation IV. STUDY RESULTS A. Overall Descriptive Results B. Investment Patterns C. Response to Fee Instruction 1. Search for Information: Fee Clicks 2. Beliefs About the Importance of Fees 3. Fund Selection D. Diversification E. Robustness: Subjects with Investment Experience V. IMPLICATIONS AND NEXT STEPS CONCLUSION INTRODUCTION
Mounting evidence demonstrates that retail investors make predictable, costly mistakes. (1) They save too little, they trade too frequently, they buy high and sell low, they invest in fad instruments they do not understand, and they pay excessive fees. In an August 2012, 200-page study prepared in response to a Dodd-Frank (2) mandate, the Securities & Exchange Commission (SEC) concluded that "American investors lack basic financial literacy." (3) The study found that investors do not understand basic concepts such as diversification, investment costs, inflation, and compound interest, and that they lack the knowledge necessary to protect themselves from fraud. (4)
Despite investors' seemingly limited competence, regulatory and market developments increasingly require retail investors to navigate the financial markets themselves. Over the past thirty-five years, participant-directed 401(k) plans have largely replaced professionally managed pension plans. (5) Unlike traditional pension plans, participant-directed 401(k) plans place the responsibility for critical investment decisions in the hands of employees, who select their own investments from a menu of employer-provided alternatives. This means that low-level employees--individuals with even less investment knowledge than the general population (6)--are now investing for retirement with almost no guidance.
To complicate matters further, mutual funds are the dominant investment option provided by employer-sponsored 401(k) plans and the primary way in which retail investors participate in the stock market, both in and outside of retirement plans. (7) Unlike other equity investments, notably stock, mutual funds are held primarily by individual investors. (8) This market segmentation means that retail fund investors cannot benefit from the market discipline exercised by more sophisticated institutions. (9)
As a result, there are reasons to doubt the efficiency of the mutual fund market and to ask whether the market offers retail investors reasonable and comprehensible investment options. In particular, many commentators are puzzled by the large number of fund choices and by the persistence of high-fee funds that underperform the market. (10)
Congress, the SEC, the Department of Labor, and the courts have struggled with the possibility that market forces are insufficient to protect retail investors from making poor investment decisions. Regulatory responses designed to protect investors include mandated disclosure requirements, product limits, and the imposition of fiduciary duties on employers, brokers, and investment advisers. Widespread litigation over the role of judicial oversight of mutual fund fees and the scope of employer obligations in designing retirement plans raises questions about the manner in which individuals make investment decisions. In one such high profile case, Seventh Circuit Judges Richard Posner and Frank Easterbrook, although reaching opposite conclusions about investor behavior, each suggested that the manner in which such decisions are made is critical to evaluating the appropriate level of regulatory intervention. (11)
The importance of understanding investor behavior is not limited to the litigation context. With employees' increasing dependence on their 401(k) plans to deliver retirement income, employers are rethinking issues such as plan structure and the choice of investment options. (12) BrightScope's highly publicized online ratings and rankings of 401(k) plans have heightened employer attention to the importance of plan design. (13)
Congress has recently acknowledged the need for a better understanding of investor behavior. In the Dodd-Frank Act, Congress instructed the SEC to conduct a study of investor financial literacy. (14) The SEC's study was conducted at the most superficial level, however, and provided limited insight into developing future regulatory policy. (15) Although the SEC found investor mistakes and misconceptions, it did not seek to identify the reasons for these mistakes or to understand the underlying mechanisms driving investor choices. (16)
This Article takes up where the SEC study left off. We report the results of an experiment designed to explore how investors use the information provided to them, and why they often ignore it. Using a simulated investment game in which participants were asked to allocate funds in a retirement account among ten mutual fund alternatives, we offer some insights into how individuals seek and assimilate information about a fund's characteristics. In particular, our experiment offers a novel addition to the body of experimental evidence on investor decisionmaking by incorporating a technology that allows us to collect data on the specific information that investors choose to view.
In addition to collecting general information about the process by which investors choose among mutual fund options, we employ an experimental manipulation to test the effect of an instruction on the importance of mutual fund fees. Pairing this instruction with simplified fee disclosure allows us to distinguish between motivation limits and cognition limits as explanations for the widespread findings that investors ignore fees in their investment decisions.
Our results offer partial, limited grounds for optimism. On the one hand, within our simplified experimental construct, our subjects allocated more money, on average, to higher-value funds. Furthermore, subjects who received the Fees instruction paid closer attention to mutual fund fees and allocated their investments into funds with lower fees. On the other hand, the effects of even a blunt fee instruction were limited, and investors were unable to identify and avoid clearly inferior fund options. In addition, our results suggest that excessive and naive diversification strategies are driving many investment decisions.
Our findings are concededly preliminary. More important, because of the simplified nature of our experiment, our results may not fully explain real-world investment decisions, in which the stakes and the cost of gathering and evaluating investment information are much higher. Nonetheless, our research offers a starting point in terms of both understanding investor behavior and evaluating efforts to improve the quality of investor decisions. In particular, determining whether effective investor education is possible is critical to evaluating the manner in which we regulate, structure, and evaluate retail investing options such as retirement plans.
The Article is organized as follows. Part I briefly describes the regulatory environment for mutual funds and 401(k) retirement plans. Part II identifies key findings on retail investor decisionmaking and observes how these findings cast doubt on the effectiveness of market discipline in the mutual fund market. Part III describes our experiment structure. Part IV reports our results. Part V explores the implications of our findings and identifies next steps for additional research.
THE REGULATORY ENVIRONMENT FOR MUTUAL FUNDS AND 401(K) PLANS
Mutual funds are the dominant investment vehicle for retail investors. (17) A mutual fund is a pool of assets that may include stocks, bonds, and other investment products. A mutual fund investor purchases shares that represent a pro rata ownership interest in the fund's pool of assets. The fund is required to value its assets on a daily basis and to purchase and sell fund shares at their net asset value (NAV). (18)
At the end of 2012, there were over 7596 mutual funds in the United States. (19) Mutual funds are typically categorized according to the types of assets in which they invest. These include funds that invest primarily in equity, funds confined to fixed income investments, and hybrid funds that combine the two. Funds may be actively managed or seek to replicate the performance of an index, such as the S&P 500. Some funds focus on a particular segment of the market, like energy stocks or pharmaceuticals; others invest in specific asset classes, like large cap equities or junk bonds. International funds purchase assets from across the globe or within a specific foreign country or geographic region. Target date funds offer a shifting mix of equities and fixed income assets that becomes more conservative as the specified target date approaches. (20)
Mutual funds do not typically hire employees to make investment decisions or perform administrative services. (21) Instead, funds outsource all operational requirements to outside service providers. The funds pass on the costs of these services to the funds' shareholders in the form of various fees. Funds' fees can include sales fees (also known as "loads"), management fees, distribution (12b-1) fees, and administrative expenses. (22) Of these fees, the largest are management fees, which are paid to the funds' investment advisers. In addition to these fees, a fund may have less transparent expenses, such as trading commissions. The cost of commissions is not included in the funds' tables of fees, but is also borne by the funds' shareholders. (23) The complexity of fund fee structures makes it difficult to calculate costs or compare different funds. (24)
As of 2012, forty-four percent of U.S. households, or...