What is selection overload, and why it paralyzes investors

What is selection overload, and why it paralyzes investors

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People want to choose. In fact, it is a fundamental principle of autonomy and freedom.

But when it comes to investing, having too many options can be counterproductive.

“Most likely, it will hurt you more than it will help you,” says Philip Chao, a certified financial planner and founder of Experiential Wealth, based in Cabin John, Maryland.

The prevailing view in economics is that many options are “obviously” good.

At that point, a “rich” environment of choice allows consumers to “create an experience tailored to their preferences,” wrote Brian Scholl, chief economist at the US Securities and Exchange Commission Office in Investor Advocate. .

However, in the real world, our experience diverges from this paradigm, he said.

People are overwhelmed by too many options, a concept in behavioral finance known as “choice overload.”

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Often, people — especially those new to something with high stakes — fear making a bad choice or regretting their decision, said CFP David Blanchett, head of retirement research for of PGIM, an investment manager.

This paradox of choice can have many negative effects on investors: apathy, or inaction; useless diversification, or spreading money around a little bit of everything; and favor attention-grabbing investments, writes Samantha Lamas, senior behavioral researcher at Morningstar.

“These shortcuts can be disastrous mistakes,” he said.

How investors cope with choice overload

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It’s not just investment: The paradox option can extend to things like ice cream flavors and clothing, for example.

Among the first research experiments: buying gourmet jam at an upscale grocery store. According to a 2000 study, by Sheena Iyengar and Mark Lepper, a tasting booth with a large display of exotic jams (24 varieties) received more customer interest than a small one with six varieties. But customers who saw the small display were 10 times more likely to buy jam than those who saw the larger one.

Because of these behavioral biases, retailers and others are evolving, making it less likely that consumers will experience an overload of choice “in the wild” today, said Dan Egan, vice president of behavior at finance and investing at Betterment.

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However, let’s say an investor wants to save money in a taxable brokerage account or individual retirement account. They usually have hundreds or even thousands of options available from which to choose, and many characteristics to compare, such as cost and performance.

“There are more options than you can use,” Egan said.

It’s a little different in the context of 401(k) plans, experts say.

Do-it-yourselfers can have about one to two dozen investment options, at most, to choose from, which reduces selection friction.

In addition, most employers automatically enroll workers into target-date funds, a one-stop shop for retirement savers that are often well-diversified and appropriately allocated based on investor age. . This eliminates most of the decision making.

If you don’t give people an easy choice, “it’s very difficult for them,” Blanchett said.

Make it as simple as possible

Finally, long-term investors who are paralyzed by their available options should make the process as simple as possible when starting out, experts say.

For most people, that tends to be investing in a well-diversified mutual fund such as a target-date fund or a balanced 60/40 fund (allocated 60% to stocks and 40 % of bonds), experts say.

“Either one of these [funds] is a very good place to start as opposed to putting all the money in cash or not investing,” said Blanchett.

Even within the TDFs and balanced fund categories, there can be many different options. Experts recommend finding a provider like Vanguard Group that has relatively low costs. (You can do this by comparing the “expense ratios” of different funds.)

Here’s another approach: If you open a brokerage account with Vanguard, Fidelity or Charles Schwab, for example, use their TDFs or balanced portfolios, Blanchett says. In these cases, you’re offloading much of the investment decision-making to professional asset managers, and the big providers are generally high quality, he says.

“Do you have to buy all the ingredients to make a cake, or can you buy a cake and eat it?” Chao said.

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