Saturday, March 6, 2010

Understanding What Choice You've Made

I recently discovered two shocking facts while reading Nudge (a brilliant book by Richard Thaler and Cass Sunstein).

The first was that many people who are investing do not understand extremely basic investment theory:

When the Boston Research Group surveyed 401(k) participants in 2002, it found that despite a high level of awareness of the Enron experience [where employees lost their life savings when the stock crashed], half of the respondents thought that their own company stock carried the same or less risk than a money market fund.
This belief is clearly incorrect. Money market funds are known to be one of the safest investment tools around - they also don't earn much interest as a result. They invest in very short term, high quality debt. In simple terms, they'll fall in value when the financial world will implode, and not otherwise. Company stock, however, is like any other individual stock. It can go up or down 5%, 10%, or more in a single day.

The second strange fact is that mortgages are extraordinarily complicated contracts that almost nobody understands:
A study by Suzanne Shu (2007) finds that even MBA students at a top school had difficulty picking out the best loans, and this was in a task that was much simpler than the one that they would encounter in the real world.
So you need to have an MBA and a law degree to understand a mortgage contract completely. That's a bit unsettling.

So here's the thing that bothers me: why don't consumers push back a little harder? Why don't we say, "I don't understand this, and until you explain it in words that I understand, I'm not buying"?

Not knowing is okay. Not knowing that you don't know is not. It's dangerous.