by FPA member David Zuckerman, CFP®, CIMA®
Last Updated: January 21, 2013
Do you like having a lot of options to choose from on a restaurant menu? Or, do too many choices make it harder to make your decision? If you’re like most people then studies have shown that having too many choices can not only make your decision more difficult, but can also result in less optimal outcomes.
Sheena Iyengar, Professor of Business at Columbia University, has conducted many studies on the effects of increasing the amount of choices available. These studies have important implications for both consumers and investors as research shows that choice overload leads to analysis paralysis.
The Jam Experiment
In a well-known study conducted by Iyengar, a jam tasting booth was setup in a specialty grocery store known for its huge selection of packaged goods. The researchers would change the booth periodically so that either 24 different varieties or 6 different varieties of jam would be offered as free samples.
The results indicate that more shoppers stop to sample jam when more variety is offered, with 60 percent of shoppers sampling jam when 24 varieties were available and 40 percent of shoppers sampling when 6 varieties are available. Greater variety obviously has some appeal, but would it translate to higher sales of the jams offered as samples? Absolutely not, as the results indicate that only 3 percent of those who sampled the large display wound up purchasing jam while 30 percent of those who sampled the small display made a purchase.
Why is there such a large difference in consumer behavior when more choices are available? Consumers are often instinctively attracted toward situations where a large number of choices are available, as more choices are often associated with more control over purchasing decisions. The reality, however, is that psychological studies have shown that people encounter difficulty objectively evaluating different options when they have more than about 7 different choices. Evaluating too many options can be so mentally taxing that people will often become overwhelmed and decide to forego making a decision altogether, a phenomenon known as analysis paralysis.
Investment Options & 401(k) Plans
Another study conducted by Iyengar was designed to determine why more people don’t participate in their company 401(k) plans. The study concluded that once variables like age, income, and company match were controlled, the biggest reason for a decline in 401(k) enrollment was caused by an increase in choice. When a 401(k) plan offered only two investment options, 75 percent of employees participated. When 59 investment options were available, however, the participation rate dropped to 61 percent.
Expanding on this study, Iyengar conducted another study that examined the impact that more investment options had on the 401(k) participants’ asset allocation. The results indicate that for every additional 10 investment options available, the average 401(k) participant’s equity allocation fell by 3.28 percent. Additional investment options were also shown to increase the likelihood of a participant foregoing an equity allocation altogether. This is significant because equities are virtually guaranteed to generate better returns than bonds or cash over long periods of time. Lower equity allocations can be the difference between a well-funded retirement and a 401(k) plan that comes up short.
How to Combat Choice Overload
One of the easiest ways to combat choice overload is to avoid offering too many different options. Just as Proctor and Gamble saw sales increase by 10 percent when it reduced the number of Head and Shoulders shampoo varieties available from 26 to 15, 401(k) providers can help boost participation in their plans by offering fewer investment options.
Analysis paralysis can also be reduced by harnessing the power of expert recommendations, which bring confidence that encourages decision making. If 401(k) plans provide participants with access to expert reports on different investment options that are easy to understand, then choosing between different investment options is less mentally taxing and therefore less likely to result in analysis paralysis.
Analysis paralysis is a suboptimal outcome that can be avoided by taking a methodical approach to the decision making process, and categorizing different options can help. A large number of choices can be psychologically easier to manager if options can be broken up into different groups.1
Lastly, it is important to recognize that not making a decision is a decision in and of itself. If you need help analyzing the different investment options in your 401(k) or determining the right asset allocation for your retirement plan, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association with the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1Sheena Iyengar and Kanika Agrawal, A Better Choosing Experience (Strategy + Business magazine, issue 61, Booz & Company Inc.)