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June 18, 2007

Investors Do Better with Fewer Choices

Investors do better if you give them fewer choices. That is the message of some new research out today from the National Bureau of Economic Research. Using panel data from U.S. 401(k) plans, it finds three things:

1. The share of investment options in a particular asset class (i.e., company stock, equities, fixed income, and balanced funds) has a significant effect on aggregate participant portfolio allocations across these asset classes.
   
2. The vast majority of the new funds added to 401(k) plans are high-cost actively managed equity funds, as opposed to lower-cost equity index funds.
   
3. Because the average share of assets invested in low-cost equity index funds declines with an increase in the number of options, average portfolio expenses increase and average portfolio performance is thus depressed

In other words, the more stock funds you give an investor to choose among, the more heavily they skew their portfolio toward stocks -- even if they are still offered fixed income, balanced funds, etc.

It's a misguided representativeness heuristic, in a sense, with people tacitly assuming that the rough proportion of the number of funds they are shown in any asset class being correlated with the target allocation to that asset class.

Classic.

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