The typical 401(k) plan offered 18 funds choices last year. Savvy investors often relish the array of options and seek out the lowest fees and best returns. But for an inexperienced retirement saver, confusing terms, fine print, and seemingly indecipherable differences between mutual funds can seem daunting. And new research indicates that too many choices in a 401(k) may even lead inexperienced investors to take on more risk than they would with fewer options.
A Rutgers School of Business, University of Texas-Austin, and University of Pittsburgh study found that many employees without extensive investment knowledge will choose a heavier concentration of stocks in their portfolio when confronted with more fund options. A large fund assortment more than doubled investment in stocks among those less knowledgeable, from 29 percent to 60 percent of the portfolio, and decreased bond fund investments from 46 percent to 26 percent. But more investment options had no significant affect on people who said they had investing knowledge.
The researchers asked 211 adults to select an asset allocation when given a choice between either three or 21 mutual funds. Those given the small assortment were offered a single fund in the three asset classes: one stock fund, one bond fund, and one money market fund. The subjects presented with a large array of choices were offered seven funds in each asset class. The fund descriptions were based on actual funds available at Vanguard, but the brand identifying information was removed. Participants were also asked to describe their own knowledge of investing. Only less knowledgeable investors allocated more resources to stock funds and fewer to bond funds when presented with a larger assortment of choices. The money allocated to money market funds did not change for either group.
Stock funds typically have more diversity in average rates of return and risk levels than bond or money market funds. "Given a set of seven stock funds, it may look like there is a lot of variety there," says Maureen Morrin, an associate professor of marketing at the Rutgers School of Business and coauthor of the study. "When people perceive more variety, they consume more. The stocks funds are sticking out more as really different from each other, which attracts dollars to that asset class."
It's not necessarily undesirable for inexperienced investors to increase the percentage of their portfolio invested in stocks. The typical 401(k) plan has approximately 65 percent of assets invested in equities, according to a survey of 1,011 plans with 7.4 million participants and more than $730 billion in plan assets by the Profit Sharing/401k Council of America. Although many new investors often shy away from stocks, the increased fund choices brought the study participants up to 60 percent in equities.
But the "menu effect," as the researchers are calling it, may be causing inexperienced investors to take on more risk than they are comfortable with or meant to without their being aware of it. "Stock funds have seen the greatest negative returns over the past few months. It's hard to cope with the wild flings we are seeing," says Jeffrey Inman, a professor of business administration at the University of Pittsburgh and another coauthor of the study. "We would advise people to sit down alone or with a financial adviser and develop an asset allocation strategy before you even look at the available choices."
Morrin says inexperienced investors should put their asset allocation on autopilot to avoid taking on too much or too little risk in their 401(k)'s. "Invest in target date funds or lifestyle funds where you don't have to decide how much goes into stocks and bonds," says Morrin. "Over time, the fund automatically reallocates as you get closer to your retirement date."