Investment Knowledge Boosts Portfolio Returns
Investing knowledge enhances risk-adjusted returns by at least 1.3 percentage points annually. Over a 30-year investment span, the improved portfolio performance leads to 25% greater wealth. This was the finding of a study, possibly for the first time, linking results from a test of financial knowledge to actual portfolio performance. The researchers believe their conclusion may understate the actual return differential.
A key driver of the return differential is a willingness to invest in stocks. The most knowledgeable investors had a 66% allocation to stocks, whereas the least knowledgeable held about 49% of their retirement assets in stocks. The larger stock allocation did lead to more volatility, but also higher risk-adjusted performance.
Researchers with the Pension Research Council at the University of Pennsylvania’s Wharton School gained access to the retirement plan of a large financial institution with 22,000 employees. The defined-contribution [401(k)] plan offered 16 funds. The plan’s offerings included stock funds, bond funds and a real estate investment trustindex fund. The study’s authors used this data to analyze account balances, returns and volatility.
Employees were also invited to take an online survey. The survey measured the ability to do a simple interest rate calculation, tested respondents on their understanding of inflation, looked to see how well respondents knew the difference between a stock and a mutual fund and how well they understood risk diversification, determined their understanding of the impact of tax incentives for saving and measured knowledge of employer match incentives.
Respondents to the survey invitation (about 16% of employees) got an average of 3.7 out of the five questions correct. A question about how much a $100 contribution to retirement savings would reduce take-home pay for someone in the 25% tax bracket contributing $100 pretax was only answered correctly by 45% of respondents. (The contribution reduces take-home pay by $75).
The researchers noted that those who responded to the survey invitation were “were somewhat better off, had higher plan balances, and contributed more of their salaries to their retirement accounts” than employees who did not respond. The researchers say this difference suggests that “the positive association between financial knowledge and investment returns may be understated.”
Source: “Financial Knowledge and 401(k) Investment Performance,” Robert Clark, Annamaria Lusardi and Olivia Mitchell, Pension Research Council Working Paper, May 2014.