Sometimes we don’t make the obvious choice or the one that makes the most sense or even the favorite.
A scientist ran a study where participants were given a choice between two candy bars. Of course, they picked their favorite. But when the number of choices increased, they were less likely to do so.
In one recent experiment, Paul Glimcher, a neuroscientist at New York University, and collaborators asked people to choose among a variety of candy bars, including their favorite — say, a Snickers. If offered a Snickers, a Milky Way and an Almond Joy, participants would always choose the Snickers. But if they were offered 20 candy bars, including a Snickers, the choice became less clear. They would sometimes pick something other than the Snickers, even though it was still their favorite. When Glimcher would remove all the choices except the Snickers and the selected candy, participants would wonder why they hadn’t chosen their favorite.
Simply put, people behave differently when faced with many choices as opposed to a few. Or, fewer choices lead to more rational decisions.
Image if a similar thing happened with, say, picking from a list of funds in a bloated 401k plan. It’s fair to say that many investors are picking a second or third rate fund over the best in class.
More choices is the mantra of the fund industry. Even Vanguard, considered one of the best, has 175 funds to choose from or about 167 more than most people ever need. And the number of funds keep growing. New indexes are created and benchmarked to a fund based on the latest factor du jour.
Really, it’s more complicated than that.
A slew of variables – some relevant, some useless – are weighed to decide an allocation, the type of funds to fit that allocation, and, a few years later, new funds to replace the old funds that don’t meet certain expectations. Goals, time horizon, risk appetite, expected returns, factor tilts, market valuation, performance anxiety, FOMO, and what that guy said on CNBC are just some of the things that weigh on an investor’s decision. Oh, and don’t forget the thousands of funds to choose from.
In many ways, the deck is stacked against the average person from making the “best choice.”
And uncertainty or lack of experience plays a role too.
Luckily, decision making usually improves when you make similar choices more often. But most people aren’t repeating the “which fund to choose” conundrum often enough to quickly improve their decision-making skills. If anything, it’s only happening once every few years. Besides, gaining experience in the market usually takes decades, not days.
One solution for all of this, besides asking for help, is to remove the worst options. With that bloated 401k plan, removing the funds with the highest fees come mind. Slimming down your options to two or three gives you a better chance of making a rational choice.
The Neuroscience Behind Bad Decisions
- Why Predicting Behavior is So Hard – Farnam Street
- Expectations vs. Forecasts – M. Housel
- Are Index Funds Communist? – M. Levine
- The Fundamental Reason Buffett Beats the Market – N. Smith
- Be Mindful of Rich Valuations in Low-Volatility Stocks – Morningstar
- Why the Stock Market will Soon Favor Value Investing Again – Marketwatch
- Superman and Stocks: It’s not the CAPE, it’s the Kryptonite – Musings on Markets
- Deutsche Bank’s $10 Billion Scandal – New Yorker
- OTL: The Implosion of the Daily Fantasy Industry – ESPN