Investors who are looking to make new investments have a lot more choices than ever before. There are now
more than 27,000 U.S. open-end funds to choose from.
While most people may assume that having more choices is better,
research suggests that it could be the opposite. Multiple studies have
shown that when presented with myriad options in the market, investors
may experience choice overload, a bias caused by being overwhelmed
with too many options. This can bring a slew of problems for both
individual investors and their advisors.
3 ways choice overload impacts investors
Investors give up and do nothing. A study conducted by Sheena S. Iyengar, Gur
Huberman, and Wei Jiang (2003) found that employee participation
rates in 401(k) plans are higher in plans with fewer options.
Notably, for every 10 funds added to the plan, employee
participation rates dropped by 1.5%-2%. When faced with more
options, many people chose to not engage instead.
Investors choose whatever grabs their immediate
attention. Brad M. Barber and Terrance Odean (2007) did an
interesting study that examined the effects of media
coverage on a fund’s inflows and investors’ buying behaviors. They
found that individual investors gravitated toward investments that
had recently grabbed the public’s attention, whether it was
appearing in the news or having abnormal trading volumes and
returns. That means investors are more prone to purchase stock of
which prices were temporarily inflated, leading to disappointing
Investors fall into the trap of naïve
diversification. A study conducted by Shlomo Benartzi and Richard
Thaler (2007) found that the percentage that employees invested in
their retirement savings plans correlated positively and
significantly to the relative number of equity funds in the plan.
This means that when confronted with too many choices, investors
will divide their assets evenly across all the options, instead of
selecting only suitable investments and allocating according to
their financial goals. This raises concerns that investors may not
be diversifying their portfolio in the most optimal way if they are
just basing their decision on the number of funds.
Advisors can play a huge role in helping investors avoid these
behavioral mistakes, and here are a few ways how:
3 ways advisors can help their clients with choice overload
Identify objectives. Help your clients identify
their financial goals and main criteria for making an investment
decision. Then, use that to narrow down the options, and guide them
in their choice. This will allow your clients to make more tangible
Organize and simplify. Provide structure and limit
the number of recommendations you give to clients. Categorizing or
prioritizing your clients’ options before presenting them also may
help your clients rationally judge between options.
Set time limits. Your clients may be so anxious
that it’s difficult for them to decide without a deadline. Set an
appropriate time limit for them based on the importance of the
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