Active Choosers Make Poor Choices: The Swedish Premium Pension Case

Did Active Choosers Make Good Choices?

How did people do at choosing their own portfolios? Of course, we do not have any way of knowing the preferences of individual participants, and we also do not know what assets they may be holding outside the social security system, so it is not possible for us to say anything definitive about how good a job they did picking a portfolio. But we can nonetheless compare the portfolios people actively constructed with the default fund on dimensions that sensible investors should value, such as fees, risk, and performance.

The initial default fund was chosen with some care, though also with some eccentricities. The asset allocation was 65 percent foreign (that is, non-Swedish) stocks, 17 percent Swedish stocks, 10 percent fixed-income securities (bonds), 4 percent hedge funds, and 4 percent private equity. Across all asset classes, 60 percent of the funds were managed passively, meaning the portfolio managers were simply buying an index of stocks and not trying to beat the market. That helped keep fees low, namely 0.17 percent per year. (This means that for every $100 invested, the investor is charged 17 cents per year.) That was a very low rate, especially at that time. Overall, though many would quibble with some of the choices made, most experts would consider this fund to be a reasonable and inexpensive option. We know several prominent Swedish economists who actively chose to invest in the default fund.

To see how the Active Choosers did as a group, we can examine the comparable figures for their aggregate portfolio. There are three points of interest in this comparison. First, although the allocation to stocks in the default plan was quite high, it is even higher in the portfolios actively chosen: 96.2 percent. People probably chose to invest so heavily in stocks partly because the stock market had been booming for the previous few years.

Second, the Active Choosers elected to invest nearly half their money (48.2 percent) in the stocks of Swedish companies. This reflects the well-known tendency of investors to buy stocks from their home country, something that economists refer to as the home bias. Of course, you might think that investing at home makes sense: “Buy what you know!” But when it comes to investing, buying what you think you know does not necessarily make sense. Just because you have heard about a company does not mean that you can predict its future returns.

Consider the following fact: Sweden accounts for about 1 percent of the world economy. An investor in Germany or Japan looking for a globally diversified portfolio would invest about 1 percent of his assets in Swedish stocks. Can it make sense for Swedish investors to invest 48 times more? No.

Third, the fees paid by the Active Choosers were much higher: 0.77 percent compared with the 0.17 percent charged by the default fund. This means that if two people invest $10,000 each, the active investor is paying $60 a year more in fees than the one who took the default portfolio. Over time, these fees add up. In summary, those who selected portfolios for themselves selected a higher equity exposure, less investment in index funds, much more local concentration, and higher fees.

At the time these investments were made, it would have been hard to make the case that the portfolios selected by the Active Choosers were better investments than the default fund. An interesting feature of the Swedish experience is that the launch of the fund occurred just as the bull market in stocks (and the bubble in technology stocks) was ending. Although it is impossible to specify the precise effect of this accident of timing on people’s choices (or even on the decision to launch the privatization program), the data provide some strong hints. We have already noted that the actively chosen portfolios had more than 96% of their money in stocks. Had the launch occurred just two years later, the proportion invested in stocks would almost certainly have been lower. As we saw earlier, individual investors tend to be trend followers, rather than good forecasters, in their asset-allocation decisions.

In a period in which technology stocks had been soaring, it is not surprising that the investments were also tilted toward those stocks. To give one illustrative example, the fund that attracted the largest market share (aside from the default fund) was Robur Aktiefond Contura, which received 4.2 percent of the investment pool. (This is a huge market share: keep in mind that there were 456 funds, and one-third of the money went into the default fund.) Robur Aktiefond Contura invested primarily in technology and health care stocks in Sweden and elsewhere. Over the five-year period leading up to the choice, its value increased by 534.2 percent, the highest of all the funds in the pool. In the first three years after the launch of the program, it lost 69.5 percent of its value. In the subsequent three years, the returns continued to be volatile.

In retrospect, it cannot be a surprise that a fund like Robur Aktiefond Contura would get a large percentage of the investments in the pool. Think about what people are being asked to do. They receive a book that lists the returns for 456 funds over various time horizons, along with a lot of other important information, involving fees and risk, that they are not well equipped to understand. The one thing they are probably sure of is that high returns are good. Of course, these are past returns, but investors have traditionally had trouble distinguishing between past returns and forecasts of future returns. We can’t help but imagine the following conversation going on over a kitchen table somewhere in Sweden between Mr. and Ms. Svenson.

Mr. Svenson (sipping his coffee): Wilma, what are you doing with that book?

Ms. Svenson: I am looking for the best fund in which to invest, Bjorn. And I think I just found it. Robur Aktiefond Contura is the winner. It is up 534 percent over the past five years. If we invest in this we can retire in Majorca!

Mr. Svenson: Yeah, whatever. Can you pass the gravlax?