‘Dumb Money’ Is Staring Most of Us in the Face

This article originally appeared in Bloomberg View on October 4th, 2012.

Financial pros have a long history of sneering at mom and pop investors as “the dumb money,” all the while cashing in on commissions each time a sucker sells at the bottom or buys at the top.

Now the U.S. Securities and Exchange Commission has made it official: The investing public doesn’t know what it is doing.

It took an act of Congress and 182 pages for the SEC in August to publish its “Study Regarding Financial Literacy Among Investors,” an exercise mandated by the Dodd-Frank Act of 2010. The study’s grim statistics showed that about half the investing public can’t read a stock trade confirmation and two-thirds can’t figure out how much their adviser would pocket on the sale of mutual-fund shares. After being shown documents for an account in which a customer’s broker used an outside custodial firm to hold the securities and issue the account statements, only a quarter could identify the custodian. There is more where that came from, but you get the idea.

Consider the profile of the 4,800 investors surveyed for the report, which concluded that they “lack basic financial literacy.” More than half had full-time jobs, 11 percent had part-time jobs, 70 percent had at least a two-year college degree and 63 percent had annual income of more than $50,000. We’re not talking about Mitt Romney’s indolent moochers here. The dumb money could be your neighbor. Or you.

Getting Taken

Of course, there’s ample evidence by now that you didn’t have to be Uncle Charlie in the nursing home to wind up parking your money with Bernard Madoff, or to sign up for designed-to-fail collateralized-debt obligations from Goldman Sachs. Smart money can be clueless, too.

For the moment though, let’s stick with investors who don’t work on Wall Street and don’t have an inkling that the worthwhile initial public offering is the one they will never be able to buy. So we have this new information about the public’s failure to understand finance. What do we do with it?

The report has been a jumping-off point for a lot of feel-good proposals that, sadly, are dead on arrival. The SEC says it got “many comment letters” advocating a “comprehensive financial literacy program in the United States that starts in elementary school.” Hey, a new education program sounds great. But try that one out on your strapped local school principal.

And maybe ask those principals how just plain old, non-financial literacy is working out. On Sept. 24, the College Board said reading scores on the SAT were the lowest in four decades. How do you teach people to read prospectuses when they have trouble reading at all?

The weird thing about the SEC’s comprehensive look at the failings of U.S. investors is that the effort comes even as a new law is about to unleash a flood of fresh hazards on the public. On April 5, President Barack Obama signed the Jumpstart Our Business Startups Act, a stunning piece of deregulation that will relax disclosure rules for some public companies and allow Internet stock offerings through what is known as crowd-funding.

So even as we learn that investors need more education about basics, we set them up as prey for a whole new genre of rip-offs.

There are some solutions here, and the quickest fixes are the ones that make investors smarter about fraud, not about computation of mutual fund fees:

Brokerages should be required to give customers a copy of an adviser’s regulatory record before they can open an account. Along with that, firms should reveal the number of times a broker has had a case expunged from his or her record (I’d look for a new broker if that number was more than one) and send a recap of every bankruptcy filing, every sanction by a professional organization and every lawsuit filed against the broker in state or federal court.

Head Scratching

I was heartened to see that 37 percent of the investors in the SEC study said they actually checked a broker’s records, but it was a head-scratcher that 21 percent didn’t consider “allegations or findings of serious misconduct” to be important. Get these facts under customers’ noses and make it hard for them to avoid considering them.

Firms also should explain in writing the terms of the relationship to new customers. I don’t mean boilerplate disclosures about the odious policy of mandatory arbitration that lets firms avoid court. There should be a statement in plain English saying what the firm promises. “Dear Mrs. Smith: We may say in our glossy ads that you are a valued customer, but we don’t have to put your interest before ours, and if you want to sue us, you will have to prove that we sold you something that wasn’t suitable, which is a lot harder than proving we weren’t working in your best interest.” OK, so the wording could be more delicate, but either way investors should get the broker’s commitment in writing.

Lazy investors (like the one who told the SEC, “If you can’t put it on a 4 x 5 card, I don’t want to deal with it”) should at least take smart shortcuts: First, go through the indecipherable documents your broker sent you and read the footnotes, which will at the very least arm you with material for your next cocktail party. After that, look for these words or terms: “certain proceedings,” “conflict of interest,” “fraud,” “Wells notice,” “litigation,” “Securities and Exchange Commission,” “cease and desist” and “not FDIC.” You will find all of them in the sections the smart money hopes you never read.

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