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 subsequent returns.
- 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 decisions.
- 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 decision.
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