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Even Nobel Laureates Have Trouble Investing

By Gary D. Halbert
May 24, 2005

Even Nobel Laureates Have Trouble With Investing


1.  Some Nobel Laureates Are Lousy Investors

2.  401(k) Participants Also Miss The Boat

3.  Some Of The Reasons Investors Fail

4.  Procrastination Kills Many Investors

5.  Lessons For Social Security Privatization


What do Nobel Prize winners in economics know about investments that you don’t know?  You would think a lot.  You would also think their investment portfolios would greatly outperform those of the average investor, wouldn’t you?  As it turns out, not necessarily.  A recent article from the LA Times cited a growing body of research showing some of those who claim to know the most about investing don’t capitalize on this knowledge.

The obvious intent of this article was to speak to the issue of Social Security private accounts, and the public’s inability to manage them.  After all, if a Nobel Prize winner can’t manage his own funds well, then how is John Q. Public supposed to be able to do so?

In this week’s E-Letter, I’m going to discuss the LA Times article, as well as others that discuss that workers are generally unprepared to manage their own financial destinies.  I will talk about why some Nobel Laureates as well as average workers don’t fare well when they invest their own money, and then relate this information to the Social Security private account debate.  My conclusion may surprise you, so read on.

Some Nobel Laureates Are Lousy Investors

On May 15th, the Los Angeles Times ran an article discussing the investment practices of past winners of the Nobel Prize for economics.  During their investigation for the article, they found that a number of Nobel Laureates did not follow even basic financial planning concepts when investing their own nest eggs.

Perhaps most surprising was their discussion of Nobel Prize winner Harry Markowitz, who is generally credited as being the father of “Modern Portfolio Theory” (MPT).  MPT is an investment discipline that stresses diversification among various asset classes to reduce portfolio risk.  In 1952, Mr. Markowitz scientifically proved the old adage; “You shouldn’t put all your eggs in one basket.”  He won a Nobel Prize in 1990 for his efforts.

The LA Times article pointed out, however, that in reality, Mr. Markowitz was less than diligent in practicing what he preached.  While MPT advocates wide diversification, Markowitz split all of his money right down the middle, with half in a stock fund and the other half in a conservative, low-yield investment.

He now admits that he should have allocated more of his assets to stocks when he was younger, but the fact remains that he wasn’t very good at following his own advice.  Unfortunately, he’s not alone among Nobel Prize winners.

George Akerlof, a 2001 winner of the Nobel Prize in economics currently has a significant percentage of his investments in money market accounts, which have very low returns.  He confesses, “I know it’s utterly stupid.”  Nevertheless, his personal investment strategy seems to fly in the face of discoveries by prior Nobel Prize winners.

In all, the LA Times surveyed 11 Nobel Prize winners in economics from this decade and several others from the 1990s, and many admit that they fail to manage their retirement savings properly.  The most often-found faux-pas was that they had too much of their money invested in low-yielding, conservative investments rather than in stocks that have historically provided better returns.

The LA Times article went further and asked Harvard University about the investment habits of its faculty.  They found than an estimated 50% put all or most of their retirement savings into low-yield money market accounts.  In many cases, contributions were left in money market funds simply because the Harvard faculty and staff didn’t bother to provide any investment direction (advice) for their accounts.

The obvious implication of the story is to say if “smart” people like college professors and Nobel Prize winners can’t manage their own money, then how does President Bush expect the average American to do so in a Social Security private account?  The Internet “blog” website “Say Anything” put it a little differently, concluding that the premise of the LA Times article is to “…convince you that if Nobel Prize winners can’t figure out investing, then you’re obviously too stupid to do it…”

The problem that I see with the LA Times article begins with its title, “Experts Are at a Loss on Investing.”  Since when are all Nobel Prize winners in economics experts about investing?  OK, I’ll admit that Markowitz should have done a better job investing his retirement savings, but all economists are not necessarily also investment experts. 

Economists are supposedly experts at observing economic data, trying to make sense out of it, and then providing some sort of prediction about future economic conditions.  But given how often economic predictions are wrong, this may explain why these people don’t follow their own advice.   An economist observing economic events is no more guaranteed investment success than a meteorologist observing weather patterns is guaranteed sunny skies.

The same goes for the faculty and staff of Harvard University.  Since when are they all investment experts?  How many of the estimated 50% in money market accounts were “smart” faculty versus lesser-educated staff members?  Or, are you automatically deemed to be smart just because you work for a lofty university?

401(k) Participants Also Miss The Boat

Unfortunately, recent information regarding 401(k) participant investment practices adds fuel to the “too stupid to invest” argument made by the LA Times article.  Since most 401(k) plans are set up to allow workers to call their own investment shots, employees must decide for themselves which investment alternatives are most appropriate for them.

Unfortunately, many 401(k) participants are not very effective in managing their retirement plan accounts.  Various studies have been performed over the years regarding the investment habits of 401(k) participants.  The most frequent problems encountered are:

1.         Various studies and industry surveys show that over 25% of employees elect not to participate in their employer’s 401(k) plan.  This is true even though most employer plans offer some level of “matching contributions” by the employer, meaning that employees are leaving free money on the table.  These matching contributions amount to an immediate return on employee contributions, so not participating is clearly not prudent.
2.         Many employees who do participate contribute only a small percentage of their compensation, well below the maximum allowed.
3.         A number of participants fail to manage their 401(k) contributions at all, leaving their money in cash accounts or invested according to “default” allocations provided by the plan.
4.         Some of the participants who do manage their accounts do so too conservatively, much like the Nobel Prize winners discussed above.  They put most of their money in safe, conservative investments that provide little growth over and above inflation.
5.         Still other participants invest far too aggressively, especially when stock in the employer’s company is an investment option.  Some employees feel disloyal if they do not allocate a large portion of their 401(k) account to employer stock, but this can be a very aggressive strategy and lead to huge losses.
6.         Many workers tap into their 401(k) balance via participant loans without recognizing the consequences.  For example, if the worker changes jobs and rolls over his or her balance into a Rollover IRA, the loan cannot be rolled over, and becomes an immediate taxable distribution, and may be subject to an additional 10% penalty tax if the worker is under age 59½.

In some cases, the lack of participation in an employer’s 401(k) plan is because certain workers feel they do not earn enough to be able to afford to participate.  Yet for those who do participate, it is stunning how many are not managing their contributions effectively.  Even though Department of Labor rules require employers to provide general financial and investment information to 401(k) plan participants, many still experience dreadful returns.  

Even though government regulations attempt to educate 401(k) plan participants, they appear to have the same problem as “smart” Nobel Prize winners and college professors: they often fail to make needed decisions about how to invest their retirement money, and when they do make decisions, they are often bad ones. 

Obviously, these problems don’t just pertain to Nobel Prize winners and 401(k) participants.  These problems are evident throughout the investment public.

Possible Reasons For Failure

So far, I have highlighted articles and studies that illustrate how many people have a hard time managing their investments.  By combining these sources, I have tried to point out that a person’s level of education does not always mean that their investment management will be any more successful.   There are many workers with a broad range of financial education and sophistication that do effectively manage their 401(k) and IRA investments.  So what’s the difference between those who can and those who can’t?

I think the answer lies in the emotional aspects of investing.   In other words, there are some people who are emotionally capable of handling the ups and downs of the markets, while others would rather do nothing (money market accounts) than have to worry about the possibility of losses.  There are those who can select a broad range of investments and leave them alone, while many others feel they have to chase after the hottest returns and frequently switch their money from one place to another.

I have often written about this latter group, the ones who are always chasing hot returns.  Various studies over the years have shown how they actually end up hurting their long-term returns by “buying high and selling low.”  Boston-based Dalbar, Inc. just recently released the latest update of its “Qualitative Analysis of Investor Behavior” study.   It shows that over the past twenty years, the average investor’s returns are 9 percentage points LESS than the S&P 500 Index return, primarily because of frequent switching to chase the highest performance.

While education may help you explain why your emotions react in a certain way, it doesn’t necessarily override these emotional responses.  I think that’s one reason why various Nobel Prize winners did not act upon the knowledge they had.  Knowing something is one thing; being emotionally prepared for the consequences is quite another.

I see this often in my company.  We always gauge the “risk tolerance” of a prospective client before we present an investment recommendation.  On a questionnaire, investors will frequently indicate that they have a great amount of tolerance for investment losses, since they have been educated that you have to take some risk to achieve potentially higher returns.

However, true risk tolerance comes into play when losses stop being theoretical and start to affect the actual value of their investments.  I have had investors who indicated on their questionnaires that they were aggressive investors and could tolerate significant losses from time to time, only to discover that they were ready to run for the exits at the first sign of losses.

That’s why I have designed our questionnaire to attempt to address the emotional issues related to investing.  For example, our questionnaire asks how large a loss could you tolerate, but it also addresses the issue a different way, by asking you specifically how you would react if a 15% loss actually occurred in your account. 

If you would like to know more about your own risk tolerance, and what type of investor you are, you can fill out our Confidential Investor Profile CLICK HERE – and we will give you a free analysis of your responses.

Many readers have already done this, and some were very surprised at the results.

Procrastination Kills

The employee benefits industry has become concerned about the lack of participation and investment direction now evident in 401(k) plans.  As a result, they have engaged behavioral scientists to help explain why employees fail to act upon issues that are very important to their long-term retirement needs.  Some of the results are surprising, while others are not.

First, the researchers found that having too many investment choices in the plan will actually work against participation.  Even when provided general financial and investment education, most employees do not feel competent enough to make their own investment decisions.  When you couple that uncertainty with having to choose from among 20 or 30 mutual funds, it only gets worse.  Employees are so afraid of making a wrong decision, that they often make no decision.

A second finding is that many employees do not participate or do not manage their accounts just because of plain old procrastination.  They know they should do it; they have been given the education and tools to do it; but they just haven’t quite gotten around to it yet.  For these individuals, no amount of generic financial education will goad them into action. 

My take on procrastination is not that it is only a lack of will to take action, but is indicative of a deeper problem.  Most people procrastinate on doing things that they dislike, or do not feel comfortable doing.  Since most employees are not experienced in investing, they put off making decisions regarding their retirement.  They do not want to commit the time and study necessary to do a good job, so their retirement needs remain unmet.

Employers and the investment industry are taking steps to help relieve these problems.  First, many employers allow for automatic enrollment into the 401(k).  This works by automatically enrolling the employee into the plan at a minimal level of contribution, unless the employee specifically opts out.  This gets more employees in the plan, even if at minimal levels of participation, by using procrastination to their benefit.

Another solution is to provide “default” investment alternatives for employees who cannot or do not make their own investment elections.  Some employers provide pre-set default portfolios that range from conservative to more aggressive, and the employees can choose among them.  While this subjects employers to some higher degree of liability, most feel it is not as great as the liability that may come later on when the employee has accumulated too little for retirement by having too much invested in cash accounts.

The investment industry is getting in on the act by developing mutual funds that take the guesswork out of asset allocation.  This is accomplished through what are known as “lifestyle funds,” which seek to provide automatically diversified asset allocations based on the participant’s age, risk tolerance and expected retirement date.  These funds are designed to be appropriate as a single investment, so the participant need only make one decision.

The problem with these funds is that they do not take into consideration the unique financial situation of each 401(k) participant.  Rather, it’s a “one-size-fits-all” investment technique.  Even so, if availability of these funds helps an employee participate who would otherwise not do so, then I think they are appropriate.

Another recent study by CIGNA Retirement & Investment Services indicated that 89% of employees in 401(k) plans would like to have personal financial planning advice for their 401(k) plan investments.  This CIGNA finding mirrors an earlier survey conducted by Vanguard that indicated 80% of 401(k) participants wanted professional advice in managing their accounts.  Perhaps these studies show that employees are not as interested in a one-size-fits-all mutual fund investment as they are in having someone make sense of all of the information and options they have been given. 

Applicability To Social Security Private Accounts

As I discussed above, the overall purpose of the LA Times article was to extrapolate the experiences of Nobel Prize winners and college professors to illustrate how Social Security private accounts will not work.  Other articles I have read say the problems with 401(k) participants proves that private accounts won’t work.

It may surprise you, but I happen to agree with these articles, at least to the degree that they apply to workers who can’t (or don’t) make needed decisions or those who invest imprudently.  The question is whether to discard the whole idea of private accounts just because some people will not make the most of their opportunity.  To that, my answer is “No.”

America abounds with opportunities for its citizens.  I disagree with those who say that Social Security private accounts should not be allowed simply because some of the workers who choose to participate will not manage them effectively.  You don’t hear these same critics saying we should abolish 401(k) plans that have similar problems; instead, these people use 401(k) statistics as ammunition against private accounts.

The bottom line is that any proposal for private accounts should include some pre-set “default” investment portfolios for those who cannot or simply don’t get around to making an investment selection.  Perhaps this default investment would be a blend of Treasury securities as recently outlined by President Bush.  However, such an investment would continue to make Social Security tax revenue available for Congress to spend.  A better choice may be several default portfolios, including various mixes of stocks and bonds, ranging from conservative to more aggressive, as noted above for 401(k)s.  The age and income level of the worker would determine to which portfolio his or her contributions would be allocated.

The best alternative would be to require indecisive workers to seek the counsel of a Certified Financial Planner (CFP) or other qualified financial professional.  In this way, the Social Security private account could be coordinated with any other investments the person may have, and therefore be incorporated into an overall financial plan.  I discussed above that studies have shown that 80% or more of 401(k) plan participants would like to have professional investment assistance, so it’s no stretch to believe that over 80% of workers in Social Security private accounts might want the same advice.

It’s no secret that I think investors are best served by seeking advice from qualified financial planners and turning over many of their investment decisions to professional money managers.  I have no different opinion in regard to Social Security private accounts.

In my own case, even after 28 years in the investment business, all of my investment portfolio is managed by professionals.  They make all of the specific investment decisions.


What all of the studies and articles that I have mentioned in this E-Letter show is that many people have a hard time actually managing their own money.   In my own company, we get hundreds of calls every year from people who are either paralyzed and can’t make a decision, or who tried to manage their own investments and lost money.

To be sure, there are a lot of people who can effectively manage their own money, but I would venture to say that they are not in the majority of workers.  For 401(k) plans or Social Security private accounts to work, it will take a comprehensive approach to address the needs of both those who can, and those who can’t, manage their own investments.

Unfortunately, President Bush’s proposals on private accounts are long on concept but short on detail.  In a “Clintonian” tactic, I think Bush has thrown out a few general proposals to see how they fare in the polls, and is now trying to figure out the details based on comments and criticism from the press and public.

I think there is a way for Social Security private accounts to be made available to all workers, and done in such a way as to make them viable for both those who are sophisticated in investment matters as well as those who are not.  Of course, this doesn’t address the issue of where to get the money to pay for the redirection of Social Security Taxes into a private account, but that’s a subject for another E-Letter.

Very best regards,

Gary D. Halbert



Battle over Supreme nominees looms.

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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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