People are attracted to choice, but that does not mean that having more choice will lead to better decisions, or a better decision-making process. Research has shown that, in the face of too much choice, people often land up making worse decisions, or suffering from buyer's remorse – that is, if they are able to make any choice at all, with many suffering from 'analysis paralysis'. Marisa Kaplan elaborates.
'When you have to make a choice and do not make it, that in itself is a choice.' (William James, US philosopher)
'Life is a sum of all your choices.' (Albert Camus, French novelist)
Over the last 10 years the unit trust industry in South Africa has enjoyed substantial growth both in assets under management and in the number of funds available. At the end of June 1999, the industry managed R96 billion in assets and had a total of 225 funds. By the end of June this year, investors could choose from a staggering total of 899 funds, and assets under management totalled R703 billion. To put this in context, our stock market consists only of some 370 shares.
But has this dramatic increase in choice benefited investors?
On the surface, most people are attracted to choice, with more options being more enticing than a limited selection. However, research has shown that, in the face of too much choice, people may:
- Suffer from 'analysis paralysis' preventing them from making any decisions at all
- Make worse decisions
- End up suffering from buyer's remorse
Analysis paralysis
Evaluating and comparing options takes time and brain power. The more choices that are available, the more likely it is that people will delay, or even ultimately avoid, making a decision.
The findings of an experiment involving jam purchasing behaviour illustrate this tendency. Grocery store shoppers were given the opportunity to taste-test jam. Some shoppers encountered a display of six varieties, while others encountered 24 varieties. A greater percentage of shoppers were attracted to the larger display, but they were 10 times less likely to purchase jam after the tasting than those who tasted from the smaller display (3% versus 30%).
With important purchases, people may intend to consider their options carefully when they have the time to do so. However, in today's busy world, that day may never come.
For investments, a delayed decision either results in lost returns or yield while funds languish in low-interest bank accounts or, potentially more damagingly, in unintentional risk of capital loss while remaining invested at the peak of a bull market.
One study looked at a sample of almost 900 000 employees across 69 industries – all clients of US investment management company the Vanguard Group.
The findings indicated that employees who were offered retirement savings plans with more investment fund options were less likely to participate in the plans. Participation rates were highest (75%) for plans with only two funds offered and lowest (60%) for plans with the maximum of 69 funds offered. For every 10 additional funds offered, there was an associated decrease of 2% in the participation rate.
Source: Research by Sheena Iyengar, Wei Jiang, and Gur Huberman (2003)
Making worse decisions
Decision quality may be compromised when there are many options to consider. With greater choice, people are more likely to become overwhelmed and mentally fatigued. As a result, they will be more inclined to make a snap judgement rather than a carefully thought out decision. Researchers at the National Sun Yat-Sen University in Taiwan demonstrated this in the realm of online dating. Users randomly matched with more potential partners were less careful in making their selection than those randomly matched with fewer potential partners. The first group failed to eliminate unsuitable options.
In the investment context, investors are less likely to make proper asset allocation decisions when confronted with an overwhelming number of funds to choose from. Asset allocation is a key factor in determining the returns an investor will enjoy, and inappropriate allocations have far-reaching consequences.
A 2008 study analysing the retirement savings records of more than 500 000 employees across 638 institutions found that when more funds were offered, investors allocated more money to asset classes they perceived to be simpler – money market and fixed interest – and less to equity, irrespective of their time horizon and risk profile. As shown in Graph 1, for each additional 10 funds, there was an associated 3.28 percentage point decrease in equity allocation and, more worryingly, a 2.87 percentage point increase in the likelihood that a participant would not select any equity funds at all.
Buyer's remorse
When there are many alternatives on offer, our expectations are higher. We have a greater tendency to believe that the optimal choice is available, we worry that we did not choose it and we blame ourselves for making an incorrect decision. The more choices that are available at the outset, the more opportunities there are to fantasise about 'what if' scenarios and to regret our decisions – even if the initial decision was, in fact, the most favourable.
This was demonstrated in a 2004 experiment in which participants were asked to choose from a list of possible investment funds. They were randomly assigned to receive either a list of six funds or a list of 60. Those that were given the shorter list of options reported higher satisfaction levels with the decision they made than those who chose from the longer list.
In the investment environment, buyer's remorse can lead to inopportune switching as investors chase past performance. With investments you can pick up a newspaper to see how all of the funds available have performed. And, unlike a pair of shoes or a new gadget, investments are often easily redeemable long after purchase. If you are invested through an investment platform, it can be easy and free to switch between funds. However, even if there is no immediate monetary cost of switching, the longer-term erosion of value can be tremendous.
By chasing recent winners, investors make decisions by looking in the rear-view mirror and engage in a systematic process of buying high and selling low. The ensuing performance gap can be wide. Investors do not always stay invested long enough to enjoy the benefits of an asset manager's investment approach, so their investments do not always perform as well as the funds in which they have invested.
Does more choice mean better decisions?
Moderation is the best strategy for many things in life, including choice. Too little choice is stifling; but too much choice is confusing and, ultimately, counter-productive – particularly when it comes to investments. People are attracted to choice, but that does not mean that having more choice will lead to better decisions, or a better decision-making process.
Other interesting reading includes:
Academic articles by Sheena Iyengar, the author of some of the case studies discussed (see http://www.columbia.edu/~ss957/publications.shtml).
A non-academic book by Barry Schwartz – 'The Paradox of Choice'.
Our research has shown that, while our investors and advisers want choice, they prefer it to be limited. Allan Gray Unit Trust Management Limited, despite being the second largest unit trust company in South Africa, offers only eight funds. And we do not offer more than one fund in the same category.
On the Allan Gray investment platform, where you can choose from other fund managers in addition to Allan Gray, we currently offer 43 local funds including our own. On our offshore investment platform we offer 30 funds, including the Orbis funds. We do not intend to expand this offering significantly in the future – our overall aim is to ensure the choice is adequate and manageable.
We offer only funds which:
- Have been registered by the Financial Services Board (FSB), local and offshore
- Have a minimum fund size for liquidity purposes
We try to offer more choice where there is potential for differences in fund performance. This means we offer fewer fixed income funds than equity funds, and aim for a good spread across the asset classes. We also steer away from specialist/sector specific funds as they move in and out of favour.
To make space for new funds, we 'cap' the funds that have not received significant flows over at least a two-year period. When we 'cap' a fund we keep it open for existing investors, but we take it off the 'buy list' for new investors. Sometimes we will ask investors to switch out of a fund, but only if very few people remain invested.
When it comes to investments, if you have little knowledge of the sector, having less choice does not mean that you will make the right decision. If you are not comfortable making your own investment decisions, or do not have the time to do so, we recommend that you engage the services of an independent financial adviser.