Most people like having options, but too many can quickly become overwhelming. Possibilities turn into paralysis.
This is especially true in finance, where offering investors too many choices can have real consequences, such as passing up 401k matching contributions, or saving too little – or nothing all – for retirement. In one study, researchers found that for every additional 10 funds an investment plan included, participation rates dropped by 1.5% to 2%. That is, when faced with more options to select from, many people chose not to select any at all. They just walked away from the decision.
Behavioral science suggests plan managers should design the investment decision to feel more like a Costco shopping trip.
My colleagues and I recently discovered an equally harmful effect caused by choice overload when we ran an experiment investigating the impact of varying how investors could choose from three essentially indistinguishable S&P 500 index funds.
When low-cost isn’t
You’ve probably heard two suggestions about investing for the long-term:
- Try to keep your fees as low as possible. This is because, over a lifetime, fees can significantly reduce investment returns.
- Diversify your investments. A single investment may do well one year only to perform poorly the next. Diversification seeks to reduce this risk and maximize returns by allocating money among various financial instruments.
Thankfully, investors have a simplified way to keep fees low and spread their money around: Index Funds.
Because they’re composed of essentially the same investments in the same proportions, there is no discernable difference in returns, on average, from one S&P 500 index fund to another.
An index fund mirrors the holdings of a stock index. For example, if Amazon makes up 3% of the S&P 500 Index, an S&P 500 index fund will put 3% of their investments into Amazon. Because they’re composed of essentially the same investments in the same proportions, there is no discernable difference in returns, on average, from one S&P 500 index fund to another. And, because fund managers are not actively buying and selling stocks, index funds are relatively cheap. Nevertheless, it may be surprising to learn that fees for S&P 500 index funds vary quite a bit, from 0.03% for the Schwab S&P 500 Index Fund (SWPPX), to as much as 2.33% for the Rydex S&P 500 Fund (RYSYX)!
That means someone who invested $100,000 in the Rydex Fund from 6/01/08 to 6/01/18 would now have $190,947. But the person who invested $100,000 in the Schwab Fund for the same period would have $241,685. That’s a difference of more than $50,000 for a nearly identical investment! That’s more than $50,000 less for retirement!
According to standard economic theory, price differences like these should be eliminated by investors selling out of their expensive funds and buying into cheaper alternatives. Unfortunately, our research indicates this is not likely to happen if investors are left to their own devices.
According to standard economic theory, price differences like these should be eliminated by investors selling out of their expensive funds and buying into cheaper alternatives. Unfortunately…
In our experiment, we asked participants to allocate a hypothetical $10,000 across three real S&P 500 index funds (with pseudonyms). The funds were indistinguishable except for their fees, which were either 0.40%, 0.09%, or 0.04%. Because these were all basically identical S&P 500 index funds, the optimal allocation decision from a purely financial perspective would be to invest all the money into the cheapest option.
To test the impact of expensive funds when cheaper alternatives exist, some participants were free to invest their hypothetical $10,000 across all three funds, while others were constrained and could allocate to only one fund.
Unfortunately, in the free-to-invest condition, only 14% of our participants put all their money into the cheapest option. On average, participants put 27% of their money into the most expensive option, 31% into the middle, and 42% into the cheapest fund, paying an average fee of 0.15%.
By limiting their ability to diversify, we helped our participants make better investment decisions!
However, we found that modifying how participants made their investment selections—whether they could spread their money across multiple funds or just one — drove down unnecessary spending on higher-fee funds. In other words, when investors could allocate their money to only one of the three index funds, 47% put all their money into cheapest option. Put simply, by limiting their ability to diversify, we helped our participants make better investment decisions!
The Downside of Diversification
In an attempt to diversify and avoid suffering a bad investment choice, most participants in the free-to-invest condition engaged in a decision shortcut called naïve diversification. Naïve diversification is the practice of dividing contributions equally among investment options, often referred to as a 1/N strategy. For example, if an investment menu features 10 funds (i.e. N=10), the 1/N strategy will have investors put 10% of their money into each fund.
From an investor standpoint, naïve diversification offers several attractive elements. First, it satisfies the well-known proverb: “don’t put all your eggs in one basket.” Next, it’s simple to apply: just divide 1 by the number of funds available. Finally, it efficiently deals with the problem of choice overload.
However, there are significant downsides to following a 1/N strategy. For one, by indiscriminately allocating money to expensive funds, it costs investors greatly over the long term. In our experiment, over a 20-year period, participants wound up paying around four times more in fees than had they invested all their money into the cheapest fund.
Additionally, naive diversification may result in an inappropriate investment mix based entirely on a plan’s menu of fund offerings. For example, say a plan menu happens to offer a sizeable number of fixed interest investments. An investor who employs a 1/N strategy will wind up with a larger proportion of conservative investments than may be appropriate for their needs. The same goes for investment menus with a greater number of equity funds, or domestic stocks, or active managers. Given the number of investment categories, the risk of overconcentration into any one of them is almost endless.
Naive diversification may result in an inappropriate investment mix based entirely on a plan’s menu of fund offerings
Lastly, because our participants spread their money around three S&P index funds, they did NOT succeed in diversifying any more than if they had just invested into one S&P index fund. Remember, every S&P index fund is composed of essentially the exact same investments in the exact same proportion. Investing into more than one S&P index fund does nothing to add any more or different investments. One of the problems with naïve diversification is that it often doesn’t help diversify! It only succeeds in harming investors by costing them more.
Retail to the Rescue?
As my colleagues and I analyzed our data, we became increasingly concerned. Offering more investment options would only risk decreasing the number of people participating in a plan, and high-cost alternatives kept popping up. On first blush, helping investors avoid naive diversification seemed like a longshot. Thankfully, a trip to Costco provided the inspiration we needed.
Costco features only a few items in each category, while other stores include nearly 10. By simplifying its inventory, and only offering a limited number of products, Costco enables shoppers to buy what they need and move on with their lives.
Taking a page out of the Costco playbook – and with our research in mind – here are a few ways investment plan architects might improve the decision-making process for investors:
- Curate: Eliminate expensive, dominated options. Given the availability of lower cost alternatives, there is no rationale for including high-priced index funds on investment menus.
- Simplify: Similar to how restaurants arrange their menus according to food groups, investment plans can be improved by organizing their menu of funds into asset classes so that investors who employ a 1/N strategy are diversified across actual investment categories rather than across individual funds.
- Focus on value: During their allocation selections, highlight to investors when low-cost alternatives exist. By informing investors that a similar fund is available, plans can guide investors towards lower overall portfolio fees while maintaining quality and diversification.
Simply reducing options may not always be enough. Costco often features only one item in a category. Similarly, in our experiment, investors would have been better off had our menu featured only one fund – i.e. the cheapest one. Investment plans must not be afraid to be aggressive in taking thoughtful, responsible steps to curate, too.
While there is no silver bullet to eliminating all the downsides of naïve diversification, behavioral science suggests plan managers should design the investment decision to feel more like a Costco shopping trip to help investors make better choices.