Many Investors Misunderstand Investments and the Markets, NASD Survey Finds

he National Association of Securities Dealers (NASD) has announced that it has establishing the NASD Investor Education Foundation, and that it is funding the foundation with an initial endowment of $10 million. According to the NASD's December 2, 2003 press release, the foundation is a response to the "current environment in the markets" as well as a recent survey that "showed investors still have a number of fundamental questions and misunderstandings about important investment issues."

The survey, found at http://www.nasdr.com/pdf-text/surveyexecsum.pdf, was designed to measure what "ordinary investors" understand. Hence, the survey respondents represent a wide range of investors across income, gender, size of investment portfolio and type of investments. For example, about one quarter of the respondents reported having investment portfolios greater than $100,000; almost one-third valued their portfolios at less than $10,000. Likewise, over two-thirds of the respondents own stocks and 60% own mutual funds.

Remarkably (in view of the many wrong answers given to the survey questions), over two-thirds of the survey respondents (69%) described themselves as being "somewhat knowledgeable" about investing. Only 12% admitted to being "not at all knowledgeable."

The survey certainly demonstrates that investors need to acquire a better understanding of their investments and the markets. Let's examine the major findings of the survey.

First, there was considerable misunderstanding as to the basic types of investments. So, for example, 21% of survey respondents did not understand the concept of a stock, and 29% did not understand the concept of a bond. In fact, only about one-half of the survey respondents knew the definition of a "junk bond." Only 40% of the survey respondents understood the relationship between bond prices and interest rates. Almost 70% of the survey respondents did not understand why municipal bonds offer lower pre-tax yields. And 80% of the survey respondents did not know the definition of a "no load" mutual fund!

Second, a surprisingly large percentage of survey respondents (28%) did not understand that, in general, investments that are riskier tend to provide higher returns over time than investments with less risk. Indeed, only about one-half (51%) of the survey respondents knew that stocks have yielded higher average returns than other investments. Similarly, the survey asked, "What is a reasonable average annual return that can be expected from a broadly diversified U.S. stock mutual fund over the long run?" Only 40% chose the correct answer (10%). Moreover, 21% provided answers in the range of 15% to 25%!

Third, the survey respondents did not understand the risks of investing, as two survey questions illustrate. The survey listed several organizations and asked, "Which of the following organizations insures you against your losses in the stock market?" Astoundingly, nearly 50% of the survey respondents thought that their stock market losses were insured! Likewise, 70% of the survey respondents did not understand that when one buys stock on margin, he or she can lose all of the investment even if the value of the shares does not go to zero. Clearly, investors need to better understand the great risks associated with using margin to purchase securities.

The NASD survey includes a section entitled "Investment Literacy Segmentation" in order to determine which categories of survey respondents answered survey questions most accurately. The notable findings are: older (50+) respondents did better than younger (21-29) respondents; men did better than women; higher income ($100,000 and greater) did better than lower income (less than $50,000); and primary decision-makers did better than shared decision-makers.

In view of the survey results, the new NASD Investor Education Foundation is a very wise initiative.