Being Street Smart April 29/05

by Sy Harding
April 29/05

Is Investing Really That Easy?

It sometimes puzzles me how little effort, or knowledge of the markets, individual investors think they need to compete for profits on a do-it-yourself basis with professional money-managers, mutual fund managers, and Wall Street institutions.

Investors wouldn’t attempt to fix their own wiring problems, handle their own legal problems, fly an airplane, or engage in any other activity where they could get hurt, at least without gaining considerable knowledge first.

Apparently that’s not so with the majority of investors.

For instance, in 2000 a national survey revealed that even after several years of intense educational efforts by Wall Street and banks, more than 65% of investors still thought that if they bought mutual funds through a bank, they were protected from investment losses by the Federal Deposit Insurance Company (FDIC). That thought was apparently because savings deposits in banks are FDIC insured, up to a limit of $100,000 in the event that the bank goes under. No one guarantees investors against investment losses, in mutual funds, or anything else.

In 2001, the Securities Investor Protection Corporation (SIPC) was shocked by a poll it conducted. The SIPC ‘investor survival quiz’ was designed to test investors’ basic knowledge of the stock market, particularly the knowledge of late-comers who had piled into the stock market in such large numbers in the year or two before the 2000-2002 bear market began.

The quiz asked five basic questions. Eighty-five percent of those polled failed the quiz, able to answer only zero to two questions correctly. Fifteen percent were able to correctly answer three questions, and less than one percent correctly answered more than three questions. For instance, only twenty percent knew there is no agency that insures them against large losses in the stock market. The majority thought that the SEC, or FDIC, or some agency was there for that purpose. Very few understood that buying on margin consisted of buying with a 50% down payment, and in the event their portfolio dropped significantly in value, they would still owe the brokerage firm 50% of the stock’s original value.

In 2003, Applied Research & Consulting conducted a poll of investors, and prepared a study from it for the National Association of Securities Dealers.

Among other things, it found that almost 30% of corporate bond investors did not know their bonds are a loan to the company, and the bond’s yield is the interest the company is paying for the loan. They thought that like stocks, the bonds represented part ownership of the business.

Similarly, 49% did not know that what used to be called ‘junk bonds’, now known as ‘high yield’ bonds, pay higher yields because the issuing company, like a consumer with poor credit, must pay much higher interest rates for its loans.

Astonishingly, 60% did not understand there is a relationship between the price they will receive for their bond should they want to sell it, and the level of long-term interest rates at the time. That is that the price they will receive will be higher if interest rates have fallen since they bought the bond, and will be lower if interest rates have risen. And the difference can be considerable. For instance, bonds plunged 31% in value from October, 1998, to January, 2000. And they plunged 20% in just a three month period in 2003.

Of course if they hold the bond to its 20-year or 30-year maturity they will receive the same price they paid for it. Given the lack of knowledge indicated by the poll though, I wonder how many investors realize that even getting one’s money back at maturity only applies if they buy individual bonds. It does not apply if their money is in bond mutual funds, which do not ever mature, and simply fluctuate up and down.

Equally surprising, a very large seventy-nine percent did not know what ‘no-load’, as used to describe no-load mutual funds, means. Presumably they would not realize that if they put $50,000 into a fund with a 6% front-end load, their investment immediately loses 6% of its value, and they have only $47,000 invested, because the 6% is a sales commission paid upfront. Only 21% knew that a ‘no load’ fund levies no sales charge on those buying into it.

Now listen. Don’t shoot the messenger. These aren’t my opinions or my findings. I’m just reporting them. But the survey also recorded which groups of people were able to correctly answer at least seven of the ten ‘Basic Market Knowledge’ questions correctly.

And that was 46% of male investors, versus 25% of women investors; 45% of older (50+) investors, versus only 24% of younger investors (21-29); and 51% of higher income investors ($100K +), versus only 23% of lower income (less than $50K) investors.

That level of knowledge in any of the groups wouldn’t cut it in any other endeavor.

Sy Harding

Sy Harding is president of Asset Management Research Corp., publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.