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People like choice. It is indeed a fundamental principle of autonomy and freedom.
But when it comes to investing, having too many choices can be a bad thing.
“Most likely it will hurt you more than help you,” says Philip Chao, a certified financial planner and founder of Experiential Wealth based in Cabin John, Maryland.
The dominant view in economics is that more options are 'unambiguously' good.
To that point, a “rich” choice environment allows consumers to “craft an experience tailored to their preferences,” wrote Brian Scholl, chief economist for the U.S. Securities and Exchange Commission Office of the Investor Advocate.
In the real world, however, our experience diverges from this paradigm, he said.
People become overwhelmed by too many options, a behavioral finance concept known as “choice overload.”
Often people – especially those new to something with high stakes – are afraid of making a bad choice or regretting their decision, says CFP David Blanchett, head of pension research at PGIM, an investment manager.
This paradox of choice can have many negative consequences for investors: inertia or inaction; naive diversification, or spreading money across a little bit of everything; and promoting high-profile investments, wrote Samantha Lamas, senior behavioral researcher at Morningstar.
“These shortcuts can become disastrous mistakes,” she said.
How investors face an overload of choices
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It's not just about investing: the paradox of choice can extend to things like ice cream flavors and clothing.
One of the first research experiments: buying gourmet jam in a luxury supermarket. According to that 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 smaller one with six varieties. But customers who saw the small display were ten times more likely to buy jam than those who saw the larger one.
Given these behavioral biases, retailers and others have evolved to make it less likely that consumers today will experience a choice overload “in the wild,” says Dan Egan, vice president of Behavioral Finance and Investing at Betterment.
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However, let's say an investor wants to save money in a taxable investment account or an individual retirement account. They generally have hundreds or even thousands of options available to choose from, and different features to compare, such as cost and performance.
“There is literally more choice than would ever be useful to you,” Egan said.
It's a little different in the context of 401(k) plans, experts say.
Do-it-yourselfers may have one to twenty investment options to choose from, reducing the freedom of choice.
Additionally, most employers automatically enroll employees in a target date fund, a one-stop shop for retirement savers that is generally well diversified and appropriately allocated based on the investor's age. This eliminates a lot 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
Ultimately, long-term investors, paralyzed by the choices available, should make the process as simple as possible at the outset, experts say.
For most people, this likely means investing in a well-diversified mutual fund, such as a target-date fund or a 60/40 balanced fund (with 60% allocated to stocks and 40% to bonds), experts say.
'One of both [funds] is a great place to start, rather than putting all the money in cash or not investing,” Blanchett said.
Even within TDFs and balanced fund categories there can be dozens of different options. Experts recommend looking for a provider like Vanguard Group with relatively low costs. (You can do this by comparing the 'expense ratios' of different funds.)
Here's a different approach: For example, if you open a brokerage account with Vanguard, Fidelity or Charles Schwab, use their respective TDFs, or balanced portfolios, Blanchett said. In these cases, you leave most of the investment decision-making to professional asset managers, and the major providers tend to be of high quality, he said.
“Is it necessary to buy all the ingredients to make a cake, or can you just buy a cake and eat it?” Chao said.
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