PERSONAL FINANCE

October 13, 2002 | By EILEEN AMBROSE

MANY INVESTORS shoulder huge financial decisions, from how to fund a retirement that can last several decades to how to pay for a child’s college education that could cost in the six figures.

The latest evidence of this is a test on investment terms and the basics of markets and mutual funds given to 1,000 investors by the Vanguard Group and Money magazine. The average score was 40 percent, up from 37 percent on a similar test two years ago.

The majority of test takers didn’t know how much one could contribute each year to an individual retirement account, the impact of expenses on mutual fund performance and which investment has offered the best protection against inflation over the long haul.

What you don’t know can cost you.

It’s an opportunity cost. By not knowing those things, people are missing the opportunity to save, to perhaps do more with an IRA, invest in a less expensive fund or put more into equities because they have a long time horizon and need inflation protection, said Catherine D. Gordon, head of Vanguard Investment Counseling & Research in Pennsylvania.

The problem may not be a lack of information, but rather information overload, some say.

I see someone being able to call me up and ask about a Texas utility defaulting on a bond in Europe and what does it mean to the company. They can ask that, but they don’t have the context relative to other things going on, said Richard Cripps, chief market strategist for Legg Mason Wood Walker Inc. in Baltimore. Investors are drowning in information but thirsty for knowledge.

Some financial experts say investment firms need to do a better job of teaching the basics to investors. But investors need to do their part, too.

People need to apply the same amount of time to investing as you would to buying a car or house. It’s that important, Cripps said.

With that in mind, here are some of the issues that gave investors trouble on the multiple-choice financial test.

Bonds and interest rates: This relationship is often misunderstood, and only 31 percent of investors taking the test knew that when interest rates fall, the price of an existing bond or bond fund generally will rise.

Say you bought a bond that pays annual interest of 6 percent and want to sell the bond before it matures. If interest rates have fallen since the bond’s purchase and new bonds offer 4 percent, your bond is much more attractive and you can sell it for more than you paid for it. If rates have risen and new bonds carry a 7 percent rate, your bond is less enticing and you will have to sell it at a discount.

This inverse relationship may be even more important to understand now because so many investors, disillusioned with stocks, are chasing the better-performing bonds. In the first eight months of this year, the net cash flows into bond funds reached $88.7 billion, up from $51.5 billion in a similar period last year, according to the Investment Company Institute.

The fact of it is, interest rates are really, really low, and that has given bond funds an exceptionally good performance. When rates start to go up again, a lot of those bond funds will get hurt, said Peter Di Teresa, a senior analyst with Morningstar Inc. a financial research company in Chicago.

Stocks over the long haul: Seventy percent of those surveyed didn’t know that stocks generally have outpaced inflation in the long run. More conservative investments, such as bonds and money market investments, may not pay enough interest to keep up with inflation.

In addition, two-thirds didn’t know that the average annual total return of U.S. stocks from 1926 to 2001 was 11 percent.

Cripps said investors often overlook how factors such as timing can affect returns.

For example, if you invested at the top of the market in 1929 and didn’t reinvest dividends, by today you would have had an average annual return of 4 percent, he said. If you invested at the bottom of the 1932 bear market and reinvested dividends, your average annual return would have been 13.5 percent.

He suggests that investors should expect returns between those extremes.

Fund expenses: Say two mutual funds hold the same securities, but one has higher operating expenses. Only 36 percent recognized that the fund with lower costs would have a higher return.

Annual operating expenses, expressed as an expense ratio, are taken out before returns are reported. That can make them easy to overlook. But expenses can make a big difference, particularly during bear markets.

When the market was going up by 22 or 23 percent, paying 1.5 or 2 percent didn’t seem like a whole lot. But in a 6 percent environment and paying 1.5 percent. to own a mutual fund, your return gets lowered to 4.5 percent, Gordon said.

IRA contributions: Last year’s tax law raised the contribution limits to IRAs. More than 70 percent didn’t know that someone younger than 50 may contribute up to $3,000 this year, $1,000 more than last year.

Investors 50 and older may contribute an extra $500 for a maximum contribution of $3,500 this year.

Index funds: Respondents were weakest on the goal of index funds. Only 16 percent knew that the objective is to track the investment return of a specified stock or bond benchmark.

Among the reasons investors should be familiar with index funds is that, depending on the benchmark, they can offer broad diversification and often have low fees, Di Teresa said.

To suggest a column idea, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.