Photo: Kaytee Riek via Flickr
Do you like having a lot of options to choose from in your 401(k) plan, or do they make it harder to decide?If you’re like most people, having too many choices can not only make your decision more difficult, it can even lead to poor investment outcomes.
Choice overload has implications for investors because it is harder to make sound judgments from a confusing array of choices. The psychology behind this is very useful to understand.
The Jam Experiment
Sheena Iyengar, professor of business at Columbia University, conducted many studies on the effects of increasing the amount of choices available.
In one, researchers set up a jam tasting booth in a specialty grocery store known for its huge selection of packaged goods. The researchers changed the booth periodically so either 24 or six different varieties of jam were offered as free samples.
The results indicate that more shoppers stop to sample jam when more variety is offered, with 60% of shoppers sampling jam when 24 varieties were available and 40% when there were six.
Greater variety obviously has some appeal, but does it translate to higher sales of the jams? Absolutely not. Only 3% of those who sampled the large display wound up purchasing jam while 30% made a purchase after seeing the small display.
Why is there such a large difference in consumer behaviour when more choices are available? Consumers are instinctively attracted to variety, as they associate choice with control over purchasing decisions.
The reality is that it’s difficult to objectively evaluate different options when you have more than about seven different choices. Evaluating too many options can be so mentally taxing that people become overwhelmed and forego making a decision altogether, a phenomenon known as analysis paralysis.
Investment Options and 401(k) Plans
Iyengar found the same phenomenon applies to investing in retirement plans. Many people don’t participate in their company 401(k) plans. She conducted a study and concluded that once variables like age, income and company were controlled, the biggest reason for a decline in 401(k) enrollment was the over-abundance of choices.
When a 401(k) plan offered only two investment options, 75% of employees participated. When 59 investment options were available, however, the participation rate dropped to 61%.
Expanding on this study, Iyengar examined the impact that more investment options had on the 401(k) participants’ asset allocation. For every additional 10 investment options available, the average 401(k) participant’s equity allocation fell by 3.28%. Some neglected equities altogether.
This is significant because stocks usually generate better returns than bonds or cash over long periods. Lower equity allocations can be the difference between a well-funded retirement and a 401(k) plan that comes up short.
How to Combat Choice Overload
One of the easiest ways for companies to combat choice overload is to avoid offering too many different options. Procter & Gamble increased sales of Head & Shoulders shampoo by 10% when it reduced the number varieties available from 26 to 15.
Steve Jobs pared Apple’s product portfolio to just four computers when he re-took control of the company in 1997. By the same token, 401(k) providers can help boost participation in their plans by offering fewer investment options.
See if your 401(k) plan provider can hook you up with expert guidance. If you can get expert reports on different investment options that are easy to understand, then choosing between different investment options is less mentally taxing.
What if your employer has a galaxy of different choices and no in-house guidance to help you? Take a methodical approach to the decision making process, and categorize different options.
A large number of choices can be psychologically easier to manage if you break up options into different groups. You can classify your mutual fund choices according to categories like indexes, sectors, domestic equity, international equity, bonds, etc.
You can get help on your own. Not making a decision is a decision in and of itself. If you need help analysing the different investment options in your 401(k) or determining the right asset allocation for your retirement plan, seek out a qualified financial advisor that can help you make the best choices.
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David Zuckerman, CFP, CIMA, is principal and chief investment officer at Zuckerman Capital Management LLC in Los Angeles, Calif. He serves as CFP Board ambassador and director at large for the Los Angeles chapter of the Financial Planning Association.