More the merrier? Not with retirement funds
U. PITTSBURGH (US) — Employers may think that offering a multitude of retirement fund options is helpful, but research shows that too many choices only bewilder the ordinary investor.
A new study finds that investors rely on simplified diversification strategies that can lack thoughtful analysis and ultimately create portfolios that aren’t always as diversified as they appear, possibly exposing investors to increased risk and wider fluctuations in their portfolio over time.
“The research shows that people get overwhelmed by choice. It is one thing to be faced with a big assortment of mustards at the grocery store, where the stakes are low. The order of magnitude is greater with mutual funds, where you feel less informed,” says J. Jeffrey Inman, professor of marketing at the University of Pittsburgh.
As reported in the Journal of Marketing Research, when only a handful of funds are offered, it’s easier to choose funds. If a large number of funds are available, then people tend to select more funds, but spread their money evenly between the ones they choose.
For the study, four separate experiments were conducted to map the behavior of investors. The aim was to assess how fund-assortment size influenced the way investors allocate their contributions across funds.
In one experiment, retirement data from financial service organization TIAA-CREF was analyzed, showing what happened after the University of Oregon increased its investment options from 10 to 19 funds.
In two additional experiments, researchers manipulated the assortment size of hypothetical 401(k) plans, showing the effect when funds increased from three to 15, or from five to 25, respectively.
Finally, in another experiment, researchers tested investors’ “cognitive load,” adding more stress to their decision-making processes by asking them to also memorize a five-digit code.
All tests proved the point that a “larger fund assortment represents a more cognitively taxing decision context, which should increase investors’ reliance on simplified decision strategies.”
“We argue that if there are a lot of fund choices you have to wade through—say, the difference between five funds versus 15—looking at five is not so hard, but at 15, people become mentally fatigued by the task of choosing funds and end up allocating their money evenly across the funds they chose,” Inman says.
Researchers note the danger of investing in more funds simply for the sake of appearing diversified. “Investing in more funds allows investors to construct what they may perceive to be a more diversified portfolio without having to carefully evaluate and compare the attractiveness of the available funds,” they write.
Another risk is that investors commonly exhibit “decision inertia”: After they make their mentally fatiguing decision, they are unlikely to revisit the choice anytime soon.
“Unfortunately, investors often do not adequately diversify their retirement plans, holding just one or two funds in their 401(k) plans, overinvesting in an employer’s stock, concentrating their portfolios in particular fund ‘styles,’ or ‘pseudodiversifying,’ by choosing investments whose returns are highly correlated,” the researchers write.
Inman says the idea that “more choice is better is not the right approach.” Employers should give employees more guidance. He suggests target-date funds, which are those that set a retirement date and have people input all their money into the fund, as an alternative to a piecemeal approach.
“One possible solution might be for marketers of financial products to offer investors a larger number of funds to satisfy their desire for choice and variety, but to clearly categorize the options to help the investor perceive the set of offerings at a higher, more abstract level,” the researchers wrote.
Researchers at Rutgers University, the University of Texas at Austin, and Boston College contributed to the study.
Source: University of Pittsburgh