You enter a Starbucks outlet because all you want is a cup of coffee. But the barista needs more details. Macchiato, Mocha, Cappuccino, Latte, Americano, or the new Toffee Nut? Hot or cold? Short, Tall, Grande or Venti? Preference of milk? Too many decisions to be made. You become aware of people in line behind you. Should you just go with the tried and tested Cappuccino? By now, you are feeling pressured and just want to hurry up and get something and catch a table.
This scenario is by no ways a unique one. Baskin Robbins has 31 flavours vying for your attention. A huge wedding buffet has tables laden with dishes from different cuisines. Shopping for a bottle of wine. Buying toothpaste. Deciding which mutual fund to invest in from the thousands available.
Consider this 1995 seminal study by Sheena Iyengar at Columbia University. In a California gourmet market, a booth of samples of Wilkin & Sons jams was set up. The displays were of two types: either six flavours or an extensive assortment of 24. This is what happened.
- On an average, customers tasted two types of jam, regardless of the size of the assortment
- Around 60 per cent of customers were drawn to the large assortment
- Around 30 per cent of the people who had sampled from the small assortment decided to buy jam
- But only 3 per cent of those confronted with the two dozen jams purchased a jar
One would assume that with a larger array of jams available, there would be a higher chance that customers would find an option they liked and would buy something. But more choice adds to the confusion. Decision making gets tougher. It uses up mental energy—of which we have a limited supply.
When choice overload works in tandem with time constraints, it adds psychological pressure to the decision-making process. This complicates all kinds of important real-life decisions, such as choosing a house to rent, or a car to buy, or, a tax-saving mutual fund to invest in before the financial year ends.
Paradox Of Choice In Investing
Choice overload is the phenomenon that occurs when too many options are presented. Having many available options seems like a good thing. But, vetting all of them is an overwhelming task.
Psychologist and author Barry Schwartz has delved extensively on the issue of how extensive choice becomes detrimental to our psychological and emotional well-being. In a TED talk, he spoke about a study based on the investment records from Vanguard with reference to voluntary retirement plans. For every 10 mutual funds the employer offered, the rate of participation went down 2 per cent. So if 50 funds were offered, 10 per cent fewer employees participated than if they were offered just five funds to choose from.
Why? Because it is difficult to make a choice between 50 funds, so you postpone it to tomorrow, and tomorrow never comes. Making the decision is so strenuous that they pass up significant matching money from the employer.
While most people might assume that having more choices is better, research suggests it could be the opposite. Individuals faced with choice overload often experience greater levels of decision fatigue and unhappiness. Especially when it comes to investing, it could lead to choice avoidance and decision paralysis. Investment paralysis serves no good purpose and can also deal a severe blow to your wealth creation plan. Here’s how you can navigate this conundrum.
Don’t choose whatever grabs your immediate attention: You may gravitate toward investments that have recently grabbed eyeballs. It could be a fund manager who has been making numerous appearances in the media, the latest one-year chart toppers, a stock discussed heavily in social media, or, a much talked about IPO. This often happens when it comes to sector funds. When pharma funds were doing exceptionally well not too long ago, they were the rage. But, the best time to enter a sector fund is when it is going through a slump, not when it is shooting out the lights.
- Don’t fall into the trap of naïve diversification: When confronted with too many choices, investors might end up dividing their assets across all options, instead of selecting only suitable investments and allocating them according to their financial goals. You do not need to be invested everywhere. You also do not need to have every single investment style or asset in your portfolio. It is neither desirable, nor optimal.
- Look towards existing solutions: If the number of diversified equity funds seems overwhelming, start with an index fund. A target-date fund or a balanced advantage fund will also allow you to side-step the process of finding a suitable asset allocation. Start simple. Don’t let the overload of choice paralyse you.
- Elimination helps: If you enter the ice cream parlour and decide that you are only going to have chocolate ice cream, you automatically eliminate most options. Now you agonise only over chocolate chip, dark chocolate, chocolate with peanut butter, chocolate with caramel, or bitter chocolate. If I enter Starbucks, I know that I want a hot coffee, I am certain of the size and I never touch Espresso or Macchiato or anything with whipped cream.
When it comes to investing, the time frame is a good eliminator. If you need to be invested for the long term, then you will automatically eliminate debt funds and look at equity funds. If you need the money to be parked only for a very short period, or even a few years, you automatically eliminate equity funds. Once you decide on the objective, the options get narrowed. If you do have a very long-time frame, but are not comfortable with risk or undue volatility, eliminate mid- and small-cap funds.
- Take another’s opinion: Talking to someone will also help you identify what to prioritise. Talk to your spouse. Talk to people whose opinions matter. It helps to bounce ideas off someone, and when you articulate your views, you will get immense clarity on what matters to you. For example, if you are preparing to make a retirement decision, narrow down what metrics are important for you. Almost everyone says they will travel when they retire, but maybe you hate travelling and you would rather potter around your garden. Focusing on your desires will make it easier for you to make a decision.
- Don’t sweat it out: Once you make an informed decision with the information available to you, turn out the undue noise and stay focused on achieving your goal at a fixed pace. Don’t keep second guessing your moves. Even if you make a mistake, it is not the end of the world.
The author is investment specialist at Morningstar India