Even Nobel Laureates in Economics Don't Invest Wisely

If brilliant economists can't invest wisely, what chance do the rest of us have? A while ago, I finished reading High Wire: The Precarious Financial Lives of American Families. One of the interesting points of the book was how the emphasis on 'investor choice' has led to increased financial risk because most people don't invest wisely (italics mine):

Even more disconcerting, recent research suggests that many people don't behave anything like the economically savvy men and women that the on-your-own, free-market system requires in order for them to succeed. They shut down in the face of multiple choices. Offered the same investment, but with low and high fees, they go for the high ones. In effect, they walk away from free money. It is not a confidence-inspiring set of behaviors.

The mistakes have taken their toll. In 2004, the last year for which figures are available, the median balance of 401(k) accounts for households closing in on retirement with adult members fifty-five to sixty-four was $83,000, according to the Federal Reserve. That may seem like a reasonable amount, but it is only enough to buy monthly benefit payment of about $570. The general rule is that family's personal retirement savings should be enough to make up at least half of their preretirement income. This would barely enough to keep a couple above the poverty line.

Even economists do a poor job:

In committing the kind of investment errors that have produced these results, ordinary Americans are not alone. Many Nobel winners admit to similar errors. Some of the nation's most prestigious educational institutions have built the mistakes right into way they operate their retirement systems. Markowitz won the Nobel for devising elaborate methods for handling investment risk. But he admits that he didn't take on enough risk when he was young by pumping more of his money into stocks. He explains his decision this way: "If I'd gone too high on the [risk] frontier, I would have gotten ulcers."

Douglass C. North won the prize in 1993 for work on the importance of institutions in fostering growth. But when it came to investing his $400,000 share of the prize money, he trusted his gut, rather than institutions. He decided the stock market, which, as it would turn out, was only halfway through its long bull run, had peaked, he pumped the money into low-interest municipal bonds. As a result, he said, "My wife spent years berating me." Still, he stubbornly hung on to those bonds, and stocks eventually reversed course and plunged. The chief benefit, he said, was "my wife quit berating me"

Joseph E. Stiglitz, who won the Nobel Prize for his work on how "imperfect information" affects economic decisions, was studying investment in the mid-1970s when he decided to put all of his retirement money into stocks. The problem is that he then went on to study other things and left the money right where he'd parked it. That looked like a brilliant decision right up until the 2000 stock bust, which he said anyone could see coming. "If I'd only listened to myself;' he laments, "I would be considerably better off than I am today."

George Akerlof, who shared the prize with Stiglitz for his analysis of the mismatch of information between sellers and buyers of used cars in an essay titled "The Market for Lemons," put a substantial chunk of his retirement savings into money market accounts, which until recently were a lemon of an investment because of historically low interest rates.

And these guys are not exceptions:

Markowitz, North, Stiglitz, and Akerlof are hardly alone among Nobelists in making mistakes. In interviews with a majority of the twenty-five U.S.-based prizewinners in economics, I found many who acknowledged slipping up, either by making faulty decisions or by failing to pay attention to their own retirement arrangements. Nor is the Nobel fraternity atypical of the nation's educated elite. In a survey of several premier universities, including Harvard and Stanford, I discovered that roughly half of the faculties and staffs of these institutions failed to make any decision about retirement at hiring. The result, at least until recently, was that they allowed their retirement savings to be funneled into low-earning investments. The same forget-about-it approach shows up among the 3.2 million members of TIAA-CREF, the Teachers Insurance and Annuity Association-College Retirement Equities Fund, which oversees the retirement investments of most of the nation's college professors and research scientists. One study suggested almost three-quarters failed to make a single adjustment to their retirement accounts during the long course of their careers, despite repeated urgings of experts to change the mix of their investments as they age.

What this record of slipups and inattention suggests is that the policymakers who launched the nation's quarter-century experiment in free-market retirement investment were operating on a faulty assumption. Most families, it seems, don't want to be active investors. Clearly, some do. But a huge number of people--both Nobel laureates and normal citizens--find the rest of their lives plenty demanding and can't or don't want to spare the time that their 401(k)s require. "I think very little about my retirement savings," said 2002 Nobel Prize winner Daniel Kahneman, "because I know that thinking could make me poorer or more miserable or both."

"Investment is not something you can do with your left hand, so I decided I should not do it at all," said 1987 winner Robert M. Solow.

"I would rather spend my time enjoying my income than bothering about investments," said Clive W.J. Granger, a 2003 winner.

At one point, referring to people as Homo economus had some popularity. But the reality is that most people don't think of themselves first and foremost as economic agents, but as human beings and citizens.

That is a very good thing overall, but our economic policies have to take this into account.