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AlamyBy Sheryl Garrett, special to CNBC.com
We Americans love independence and freedom of choice, believing them essential to our well-being. Yet more choice is not, it turns out, leading to more happiness or success.
I believe fewer, better choices for individual investors are what we need.
Research shows that a certain amount of autonomy around choice is required to achieve a basic level of happiness. However, after that certain point, more choice actually detracts from personal happiness. Too many choices result in feeling overwhelmed, often leading to the inability to make a decision.
Information overload, a term popularized by Alvin Toffler in his 1970 book “Future Shock,” takes place when the advantages of diversity and individualization are canceled by the complexity of a buyer’s decision-making process.
On the surface, it would appear that having more choice is a positive development. However, this hides an underlying problem: When faced with too many options, people have trouble determining the best choice and, as a result, can remain indecisive, unhappy and immobilized.
Established finance theory has assumed that investors have little difficulty making financial decisions and are well informed, thoughtful and consistent. It’s also assumed that investors are not confused by how information is presented and are not influenced by emotions.
Clearly, reality does not match this theory. Behavioral finance, on the other hand, is the study of the psychology of financial decision-making and has led to great insights on how investors actually make decisions.
Investors confused or uncertain about how to proceed become immobilized.
When too many choices are available, inertia sets in. People fail to take action, even on things they want or have agreed to do. This inertia can act as a barrier to effective financial planning, stopping people from saving and making reasonable allocation decisions and necessary changes to their portfolios.
The financial services industry is not necessarily helping investors by devising more investment options. There are currently tens of thousands of mutual funds, variable annuity and 401(k) subaccounts, and exchange-traded funds — not to mention thousands of individual stocks and bonds and a plethora of “alternative” investments.
We’ve got 401(k) plans with dozens of investment options. People make better decisions with a reasonable or limited number of investment options and the “right” amount and type of information about each of them.
The need for diversification is one reason we’re offered choices in our 401(k) plans. Investors may understand the importance of diversification, but not knowing how to achieve it, they simply adopt what we commonly call “naive diversification,” or the “1/n” approach.
Without better understanding, plan participants often simply allocate their funds equally across the range of options provided. For example, I’ve seen investors allocate 25 percent into each of four “lifestyle” funds, only to end up with the exact same allocation they’d have had if they’d selected the balanced option to begin with. But the effort lent the illusion of diversification. I argue that 20 or so investment options are more than enough to achieve proper diversification.
In her book, “The Art of Choosing,” Columbia University professor Sheena Iyengar shares a study of shoppers who are given an array of either 24 or only six different flavors of jam to select from. The research showed that “fantastic variety seems to favor browsers over buyers.” More people spent time exploring the 24 flavors, but when it came to purchasing jam, the booth displaying just six options enjoyed far more sales. Given fewer choices, people felt they could make an informed decision and complete a purchase.
Psychologist Barry Schwartz argues in his book, “The Paradox of Choice: Why More Is Less,” that eliminating consumer choices can greatly reduce anxiety for shoppers. Reducing anxiety for investors should increase savings rates and confidence around decisions taken.
The recent Dodd-Frank Act included provisions requiring that those who render financial advice to retail investors be held to a fiduciary standard no less strict than that of the Advisors’ Act of 1940, which requires all financial advisers to put clients’ best interests ahead of their own.
More choice doesn’t improve an investor’s experience. Fewer, better choices are what we need.
However, the opponents of the fiduciary standard argue that this legislation would reduce investment choices for middle-income and beginning investors. Good! As I mentioned in this column, more choice doesn’t improve an investor’s experience.
Fewer, better choices are what we need. If all financial advisers had to put their clients’ best interests first, we would see fewer choices. All the mediocre and poor investment options, which simply clutter up the decision-making process and do not serve the investor, would no longer be available.
Fewer, quality options would result in more simplistic portfolio allocations. But simplistic allocations do not have to result in less satisfactory portfolio risk-adjusted returns. Allan S. Roth, adviser and author of “How a Second Grader Beats Wall Street,” and Craig Israelsen, author of “7Twelve: A Diversified Investment Portfolio with a Plan,” among others, have illustrated the effectiveness of such an approach. Simple portfolios produce similar rates of return to more complex options, are typically available at a lower cost, are low maintenance and involve minimal stress.
What’s good for investors is not necessarily good for financial-product manufacturers and distributors, but the latter will survive and evolve. Doing what’s best for investors may require limiting their investment options — and I think most will be grateful for the added efficiency and simplicity.
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