As we barrel toward Election Day faced with a choice between two historically unpopular presidential candidates, many of us are no doubt wishing that we had a more expansive set of options to choose from, a third or fourth candidate who we could really feel good about supporting. Nobody likes feeling as though they’re choosing among the lesser of evils, and yet that’s what an increasingly large portion of the voting population seems to face in each successive presidential election.
Of course, to an investment advisor like me, the “least worst option” dynamic is an eerily familiar one. In our current market, we’re constantly forced to choose between fixed income investments boasting historically low (or even negative) yields and equity instruments with stretched valuations even amid stagnant or falling earnings. Sure, we could elect to sit in cash or commodities, but those strategies haven’t exactly been a panacea to a portfolio of late. So, just like voters who are faced with the prospect of holding their nose and voting for a candidate they dislike, so too are investors often compelled to invest in stocks with no better justification than “there is no alternative”.
This kind of repression is maddening for most of us—we crave choice because it is empowering, because we value freedom, and because we want to feel as though we control our own destiny. We therefore bemoan the situations in which we feel as though our options are artificially limited, whether in politics, investing, or just as consumers in general (think: cable companies).
And yet, too much choice can also be paralyzing. Indeed, the more options we have at our disposal, the greater a guarantee there is that we won’t end up choosing the “best possible” option. As we’ve learned from the inimitable Infinite Monkey Theorem, the more potential combinations there are in a given universe, the greater the likelihood of a true outlier event occurring—in the world of investments, this means that given enough different portfolio options, somebody will make an absolute killing in the market, and somebody else will inevitably get killed. Our desire to be exceptional on the one side—and to avoid being exceptionally bad on the other—can fuel an essential fear of missing out, preventing us from making any decisions at all.
So how does this dynamic apply to our investing choices, whether in our brokerage accounts or our 401(k) plans? Could the paradox of choice be preventing us from meeting our financial goals?
More options are not always better
In a popular and widely shared TED talk from 2005, psychologist and Swarthmore College professor Barry Schwartz noted a number of ways in which an increase in options actually makes us less happy, not more happy. At a certain point, he found, our fear overtakes our freedom, and we become paralyzed and afraid to move.
In focusing on the financial world, Schwartz cited research from a colleague of his, which studied aggregate data from 401(k) plans housed at Vanguard. That research found that for every 10 additional mutual fund options that were included in a given plan’s investment menu, employee participation actually declined by 2%. An interesting complementary study conducted at the Wharton School at the University of Pennsylvania found that 401(k) participants whose plans were streamlined to include fewer options also saved on fees, while also electing generally more conservative portfolio allocations.
The study’s authors concluded that the investors who were given more options frequently selected suboptimal strategies (and more aggressive, higher-fee options), simply because they thought they “should.” Streamlining their options helped protect them from making poor decisions, and kept them more in the “mainstream” of portfolio management.
Given the state of the current investing environment, these studies have drastic implications for investors everywhere, and not only inside 401(k) plans. Indeed, the last decade has seen a veritable explosion in investment options, as the universe of available ETFs and mutual funds now measures in the tens of thousands. For an investing populace that is already paralyzed by too much choice, further growth in the industry is likely to be increasingly counter-productive.
Simplicity, it seems, is the key, and investors—and 401(k) plan sponsors—who embrace that simplicity are likely to come out ahead over the coming decades. And yet, the face of that simplicity does matter, since not all simplicity is created equal.
Are target-date funds the answer?
In response to the widespread desire for simplicity (and also to regulatory calls for improved default options in defined contribution plans), target-date funds have exploded in popularity over the last decade. According to research from the Investment Company Institute, ICI, the share of 401(k) plans offering at least one target-date fund more than doubled in just 6 years, from 29% in 2006 to nearly 70% in 2012. And yet, target-date funds are as diverse as the companies that offer them in their retirement plans—some can be overly simplistic and not well diversified, whereas others can be so overly complex as to frankly defy understanding by the average investor.
To illustrate the differences, consider a married couple whose portfolio I recently had the opportunity to evaluate. Over a number of years and a number of jobs, the two of them had accumulated investments in three different target-date funds, and assumed that their “default” choices were not only generally similar, but also reflected their fairly moderate investment risk tolerance.
And yet, despite all three funds being nominally “2045 target-date funds,” the investment vehicles could not have been more different:
The approaches of the three fund managers differed dramatically on just about every possible level—from current allocation to future allocation to the number of funds used and even the fees charged to the investor, just about the only thing these funds had in common was their names.
Small wonder, then, that a 2012 Morningstar study found that the performance gap between the best-performing and the worst-performing 2045 target-date fund was a whopping 7.5%, from an 18.1% annual return on the high end to a 10.6% return on the low end. Given that 401(k) investors have a tendency to opt for target-date funds due to their reputation as a “safe” default option, that kind of disparity in returns should be a bit alarming, to say the least.
Of course, as the table above showed, target-date funds are anything but “safe,” especially for younger investors. With equity allocations of 90% or more, these portfolios would qualify as particularly aggressive by just about any standard. While the “100 minus your age” in equities guideline may be flawed and overly simplistic, it nonetheless persists as a useful rule of thumb. Needless to say, most target-date investors aren’t 10 years old, and the 90% equity allocations we so often see are therefore significantly out of step with traditional industry guidelines.
The illusion of choice
In order to have a properly diversified portfolio (one that strives to optimize risk-adjusted returns), industry research suggests that somewhere between seven and nine asset classes yields the best diversification results. Anything less than that, and useful diversification is hard to achieve; anything more, and diminishing returns start to take hold (along with investor paralysis and fatigue).
By that measure, the Vanguard target-date fund included above may be too simple (though its low fees are certainly alluring compared to its competitors). On the other hand, though, the T. Rowe Price and Fidelity funds are almost certainly overdoing it, making the same mistake that so many 401(k) investors make on their own (in other words, thanks Fidelity, but we don’t need any help overcomplicating our portfolios).
What also bears mentioning, though, is that even when 401(k) plan sponsors are offering too many investment options, they also paradoxically may not be offering enough! According to the ICI research cited above, “in 2012, the average 401(k) plan offered 25 investment options, of which about 13 were equity funds, three were bond funds, and six were target date funds”.
Any investment menu wherein more than half of the investments come on the equity side of the ledger, another quarter come from target-date funds that may or may not be appropriate vehicles (and most of which are likely also equity-heavy), and only a small minority come from fixed income or other asset classes simply cannot provide enough options for all employees to build appropriate portfolios for their circumstances. And yet, such a menu has become the industry standard.
Essentially, the 401(k) plan mantra has seemingly become “invest in whatever you want, as long as it’s equities.” That’s not exactly a winning solution for most investors, but it’s the current reality. Hence, the illusion of choice—even as investors are paralyzed by having too many investment choices, they’re actually simultaneously hamstrung by having too few truly different fund options.
The implications for investors (and for advisors and plan sponsors who design these investment menus) should be clear: if relying on target-date funds to provide diversification, vet your target-date fund provider carefully, to ensure that the funds are actually doing what you want them to do. Either way, the goal should not be to provide more investment choices, but more meaningful investment choices. It’s better to have 12 investment options, all of which represent different asset classes or investment approaches, than to have 25 investment options, 20 of which are highly correlated equity-heavy investments.
As we head to the voting booths on Tuesday, regardless of what choice we make, we might want to take the opportunity to reassess our investment allocations at the same time. Chances are, you’re making some suboptimal choices without even realizing it, perhaps for as simple a reason as “fear of missing out.” We may crave freedom of choice in all aspects of our lives, but sometimes freedom can be a very dangerous thing. Keep it simple, and your portfolio will usually thank you.