The Changing Nature of Investing: How Should We Rethink Teaching Our Students?

I tweeted about this earlier but thought it was worth a broader discussion as I thought about how best to teach students about investing.  This statistic from a Morningstar caught my attention:  

John Rekenthaler stated in a post that indices are dominating fund sales. Some 68%—or $284 billion—of net US mutual fund sales for the 2014 fiscal year were exchange-traded funds and passive while only 32% were active funds.

“The post-2008 pursuit of index funds was no mere infatuation,” Rekenthaler wrote. “Passive investing is now the mainstream approach.” 

Diving deeper there has been a plethora of recent articles about active management’s underperformance:

  • “Active fund management is outmoded, and a lot of stock pickers are going to have to find something else to do for a living…” (WSJ)
  • “Why Even Experienced Fund Managers Don’t Beat the Market (Economist):  “THE harder I practise, the luckier I get,” said Gary Player, one of history’s greatest golfers. And it is a widespread belief that experienced professionals are a lot better than neophytes.  But is that true of fund managers? A new study* suggests that the answer is distinctly mixed.”
  • Investors Like Passive ETFs over Active Funds (ETF Trends):  “More investors want index-based investments and exchange traded funds, favoring passive fund products over actively managed strategies. Passively managed stock and bond funds attracted $336 billion in new inflows over 2013, beating out the $53 billion in new inflows traditional mutual funds experienced…”

Full disclosure:  My personal bias as someone with 25 years of investing experience (has it really been that long since I set up that Quick & Reilly brokerage account?) including a stint in the mutual fund complex as a research analysis can be summarized simply:  Use passive investing for core stock market holdings (U.S., international and emerging markets).   Why?   1)  Fees:  1% vs. 0.05% (average fee on active mutual fund vs. popular US index fund)  2)  It is really, really, really hard for an active manager to beat the markets.  Depending on time period and research methodology, you can find figures as low as 0.6% (yes, that is 6/10 of 1%), or 24% or 39%.  Hint:  the longer the time frame analyzed, the lower the percentage who outperform.  Why?  See #1 and the drag that fees have on performance.  

OK, knowing this, what do we do about teaching students about the stock market?  The most popular method seems to be the “Stock Market Game,” in which students create fictional portfolios over a short time frame and compete against each other to see who has the largest portfolio value at the end. So, what are the benefits:

  • It’s a game and kids love games.   Check.
  • It’s real-life experience.  Check.
  • It’s backed by research.  Check.  
  • It helps students understand what moves stock prices.  Check.

As an entry point to teach students about investing, most teachers see the benefits described above and love the contest.  

Spoiler alert:  While interviewing for investment management positions almost 20 years ago, I had to recommend a stock and the rationale behind my recommendation.  To make this real-world, I took a few hundred dollars, bought some shares of Motorola in hopes that a robust new product pipeline would drive the stock higher and I would achieve a two-fer:  a job offer and a few hundred dollars in gains.  After a 30% jump in price, I took my gains and gleefully looked forward to my interviews.  As I breathlessly described by brilliant investment analysis (my Master of the Universe intuition) and how that led to extraordinary gains in Motorola, the investment manager stopped me in my tracks with these words “You got lucky.”  

Is the winner in a short-term stock market game lucky?  Hint:  Don’t ask the winner to answer this question. Yikes, just came across this headline:  Third graders outsmart high school students to win Stock Market Game.  Want to create overconfidence?  Leave out the element of luck and tell students they won based on “skills” or “smarts.”   

So, what should a next generation stock market game simulation look like:  

  • It provides students with indexing options, instead of just individual stocks.
  • It simulates stock market prices over years instead of days.
  • It rewards diversification, rather than the “high-beta” portfolios that win these contests.
  • It demonstrates the value of consistent investing over a long-time frame (dollar cost averaging) vs. frenetic trading in search of volatility.
  • It forces students to deal psychologically with “pain of losses” in addition to “joy of gains” and to analyze their behavior (after the fact).  

Please share with me any additional ideas on how we can best teach investing.  Who knows, maybe I will work with a game designer in the mean time and build my “ideal” stock market game.  Stay tuned..