The Investor's Paradox

The Power of Simplicity in a World of Overwhelming Choice

Palgrave Macmillan

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The "success" of modernity turns out to be bittersweet, and everywhere we look it appears that a significant contributing factor is the overabundance of choice.

— Barry Schwartz

THE LESSONS OF STRAWBERRY JAM

It's Saturday morning. After your coffee, you head over to your local supermarket to pick up a few items. As is common these days, especially with fancier stores like Whole Foods or warehouse stores like Costco, there are numerous stations set up where you can sample different foods for free. On this particular day, there's a table set out in the condiments section with a large variety of gourmet jams, ranging from classic strawberry to unrecognizable blends of wild berry and spice. This tantalizing rainbow of alternatives — maybe a couple dozen or so — draws you in, and you spend a few minutes sampling the jams, despite an overcrowded store and a day full of errands ahead. When you're done sampling, the table attendant gives you a "dollar off" coupon good for any of the full-size jars, which are located mere steps away from where you're currently standing.

What do you do next? If you are the typical customer in this scenario, you walk away from the samples table, walk away from the jams aisle, and buy nothing.

Let's consider another scenario, exactly the same as the first — except in this case the samples table features only six jams, versus twenty-four. What happens in this case? First, fewer customers are attracted to the booth. With just a few choices, it's not as appealing. But the outcome among the smaller set of samplers is vastly different. Those who do sample this limited menu of jams are more likely to walk down the aisle and then purchase the jam(s) they enjoyed most. How much more likely? In one of the more famous studies in the field of social psychology, ten times more likely. What's more, customers reported afterwards a relatively high level of satisfaction with the experience. The limited number of customers who purchased jams from the larger choice set reported a lower level of satisfaction.

In sum, more was less. Experiments like this one have been repeated across a range of different types of choices, with similar results.

How we make decisions has been a topic of intense inquiry since the earliest philosophers. Political views on liberty, economic views on utility, sociological and anthropological views on social outcomes, moral views on fairness and justice — these all take into consideration, implicitly or explicitly, how people and groups choose. There is now an abundance of scholarship about how our built-in cognitive and emotional biases influence the choices we make. So-called behaviorists explain the reality of how we choose, usually in stark contrast to what classical economists would call rational cost-benefit analysis.

This school of thought has been increasingly undergirded not only by countless empirical studies, but by the study of the brain itself. Technology now allows us to literally see how we react to stimuli: how the brain instantaneously processes sensory information, associates reward or punishment with a particular experience, and takes action based on that risk assessment. In her powerful The Art of Choosing, Sheena Iyengar makes clear that the desire for choice is a biological imperative. Humans have a larger prefrontal cortex than animals, which is probably why choice is so important to us, and in turn to our place in the global pecking order. Humans dominate without claws, fur, or other physical adaptations. Instead, we are smarter: "The ability to choose well is arguably the most powerful tool for controlling our environment."

But there's something more going on. The desire to choose, Iyengar writes, "often operates independently of any concrete benefits. In such cases, the power of choice is so great that it becomes not merely a means to an end but something intrinsically valuable and necessary." Our satisfaction often stems from the perception of control (what behavioralists often refer to as the "illusion" of control) as much as if not more than control per se.

To evidence the power of choice, consider a well-cited study of nursing homes. Researchers set up an experiment with two groups of elderly residents. One group was encouraged to exercise their liberty. Among other empowering directives, an attendant told them: "If you are unsatisfied with anything here, you have the influence to change it." Each person was also given the choice of taking care of a small plant; those that did were allowed to choose one of several plants from a large box. Finally, the group was asked which movie they cared to watch the following weekend. The other group received a different message — that if they would like their environment to be different, they should inform the staff, who would make the changes for them. Each resident was also given a plant that would be watered by the staff, and they were told what movie they'd be watching on Friday night. Generally, the former group was given frequent reminders that they had the power to make changes to their rooms and their routines; the latter group was not.

The results were somewhat striking. Aging individuals who were given enhanced personal responsibility demonstrated much better outcomes in the following months. Those with more control registered a higher degree of mental alertness as well as higher reported happiness. They were more likely to participate in social activities, such as movies, mixers, and game night. Finally — strikingly — they were more likely to live longer. The mortality rate in the eighteen months following the original study was double for the group with less control (30 percent versus 15 percent). Choice and control matter.

The desire for choice is not itself a choice; we are hardwired that way. It is the reason that so many more customers in the supermarket were attracted to the table with many jam samples compared to just six. Indeed, there are a litany of positive outcomes we tend to associate with more choice, such as freedom, motivation, variety, and the chance of getting what we want.

Yet here's the fascinating modern twist to the choice paradigm. The availability of options ultimately becomes self-defeating. Barry Schwartz famously describes this "paradox of choice":

When people have no choice, life is almost unbearable. As the number of available choices increases, as it has in our consumer culture, the autonomy, control, and liberation this variety brings are powerful and positive. But as the number of choices keeps growing, negative aspects of having a multitude of options begin to appear. As the number of choices grows further, the negatives escalate until we become overloaded. At this point, choice no longer liberates, but debilitates. It might even be said to tyrannize.

We want more choice, but the more choice we have, the less satisfied we become. Hence the unwillingness of most overwhelmed jam customers to purchase anything, and for those that did, to report lower satisfaction with the experience. The labels "rational" or "irrational" are not relevant here. For better or worse, it is how we decide.

Why does more often produce less? There are a few reasons. With lots of choices, we sometimes find ourselves overwhelmed, unable to process the information, let alone take action. The menu at the Cheesecake Factory or a traditional Greek diner at first amuses, but then overwhelms. (That one daily special paper-clipped to the diner's menu is there to simplify your task by giving you one choice — which is likely to be a higher-margin item than the standard fare.) We begin to think that with more options, there will likely be a better choice that we don't make; this "anticipated regret" can be paralyzing. With more choices, we expect better results, but achieving them is uncertain, thus creating yet another form of regret. And when we do actually choose but don't achieve our hoped-for satisfaction, we are increasingly likely to blame ourselves, since we did, after all, have the "freedom" to choose a better option. We find ourselves less satisfied with more choice.

CHOICE REGIMES

We're all familiar with the consequences of "choice overload," whether we're walking through the grocery store, comparing mobile phone plans, flipping through satellite TV channels, or surfing the web to purchase a garden gnome (a Google search produces about 3.8 million results). Indeed, we live in a time of unprecedented availability. In other words, what I call "choice regimes" evolve.

Let's point to three primary qualities of choice regimes: volume, complexity, and breadth. The first is the number of choices themselves, a somewhat obvious feature (e.g., 6 versus 24 jams; 3 networks versus 300 satellite channels; 1 pension plan versus 20 choices in our 401(k); etc.). The second is the dimensionality of each choice. Objects might have fewer or more features that make the latter a more "complex" choice (e.g., bicycles versus cars; cell phones versus smartphones; mutual funds versus hedge funds, etc.). The third is the number of choosers themselves. How inclusive is the regime? It could pertain to just a few individuals, or most of the planet.

We are experiencing an inflection point in choice regimes across most areas of modern life. At home, the deregulation of utilities has exploded our choice set in how we receive power, gas, and telecommunications services. In health care, the medical industry now compels us to make unprecedented choices among procedures and doctors. We are pelted with print and broadcast advertisements for prescription drugs that we couldn't purchase for ourselves even if we wanted to, yet suddenly recognize as possible solutions for potential problems. In education, the mandatory assignment to the neighborhood school has been replaced by a lattice of magnet, gifted, charter, parochial, and other private alternatives. And most obviously, in mass consumption, the number of immediately available goods is now countless, whether it be books, music, clothing, or garden gnomes. The Internet and other modern forms of communication don't just facilitate the trend; they help create it.

Most affluent societies have transformed into do-it-yourself cultures where more options are no longer just desirable — they're mandatory. It's no surprise that researchers refer to "decision fatigue," the physical and mental exhaustion many people report from having to make so many decisions so frequently. Yet we would be disconcerted if our choice sets suddenly reverted to those available a generation ago. (Three TV networks, anyone?) Regardless of your personal feelings about whether "more is less" or "more is more," the left side of that equation is now fixed. There's no going back.

THE INVESTOR'S PARADOX

The choice regime for investments mirrors what we see in consumer goods, health, education, and elsewhere. Set aside the directly purchased securities — stocks and bonds, mostly. There are countless tickers to choose from, but only a small fraction of us are trained to choose at that level. Most of us buy funds, not securities. We hire experts who themselves can purchase and assemble these securities for us. But then screen for "five star" funds on Morningstar, shop on the platforms at Schwab or TD Ameritrade, or attend (if permitted) a hedge fund "capital introductions" conference in which hundreds of allocators mingle with hundreds of portfolio managers. You'll be quickly overwhelmed.

Hence what I call the investor's paradox: We crave abundant investment choices to meet daunting portfolio problems in a world of volatile markets, manic news flow, and shifting geopolitical rhythms. But the more choices we are afforded, the more overwhelmed, less empowered, and ultimately less successful investors we potentially become. More is less.

Unfortunately, it gets worse. A generational stretch of nearly uninterrupted prosperity has recently yielded to an era of heightened uncertainty and economic stress. Fixed-income securities are vulnerable in a low-interest-rate environment like our current one, and equities are unpredictable. Because complex times prompt us to seek complex solutions, investors have increasingly gravitated toward experts with extensive tool kits and flexible modes of thinking over those who are tightly constrained or who bet only that markets climb upwards over time. The deeper, more insidious level of our investor's paradox is that the more adaptable, creative experts are also the ones more likely to disappoint because we automatically expect more from them. In the theory of choice, unmet expectations trigger powerful emotions. When expectations and outcomes don't match, disappointment ensues. And because drawing clear expectations for flexible experts is much harder than it is for those with tighter constraints, the chance the former can satisfy is lower.

31 (THOUSAND) FLAVORS

While chapter 3 will detail the factors over the past thirty years that determined how we got into our current predicament, let's tee up its salient features. There are multiple examples. If there's any area in American finance where the do-it-yourself culture has been most profound in the last couple of decades, it is in the individual selection of one's own retirement funds. The shift away from defined benefit (pension) plans to defined contribution (401(k)) plans has forced investment novices (which is most of us) to become fund analysts, and in turn to direct our own financial futures.

The paradox of choice infuses the process of picking one's retirement options. In one study, researchers examined 401(k) participation rates among clients of the investment firm Vanguard, across more than 600 plans covering more than 800,000 employees. Controlling for a large number of variables that might influence investor participation (e.g., compensation level, overall wealth, gender, tenure at the company), they found that the more funds offered, the lower the rate of participation. For every ten additional funds included in a plan, there was a 1.5 percent to 2 percent decline in the participation rate. Keep in mind that many of these plans offered matching contributions, meaning that more choice actually deterred individuals from accepting free money. Thus, for those employers who offer scores, even hundreds, of retirement plan options on the belief that more choices are better, the reality is actually the opposite.

Second, the advent of the market for exchange-traded funds (ETFs) is also emblematic of the modern investment choice regime. An ETF is a bundle of securities that aims to capture the profile and performance of a predefined market segment. The constituents of those baskets are mostly fixed, as distinct from actively managed funds in which portfolio managers buy and sell positions at their own discretion.

ETFs have grown into a multitrillion-dollar business in recent years on the back of the idea that stock pickers actually aren't very good at picking stocks. The popular but controversial efficient markets hypothesis, pioneered by economist Eugene Fama, suggests that no one can sustain an informational advantage in liquid markets (that is, markets with many buyers and sellers). This idea first sparked the growth of passively managed index funds (most popularly through Vanguard Funds) and then ETFs, which are effectively the same as index funds but can be bought and sold throughout the trading day, rather than only at the end of the day, like mutual funds.

The original premise of exchange-traded funds was that if you can't beat the market, you might as well own the market. Thus, the most popular ETFs focus on the biggest markets, such as the S&P 500. But in recent years, asset management companies have manufactured a bewildering array of additional choices. There are now more than 1,000 ETFs that divide the market into increasingly microscopic slices. Recently created ETFs that allow you to buy the market for soybeans, aerospace stocks, and Australian bonds now sit on the shelf alongside vehicles for US mid-cap stocks, gold, global technology stocks, and Russian commodities. Ironically, investors are being empowered to access precisely the markets they desire, but then they have so many opportunities that they suddenly lack the necessary expertise to select the right markets — hence the impetus for the ETF "solution" in the first place.

Third, the mainstreaming of hedge funds is the most foundational shift in our evolving universe of investment choice. In 1990, it was an industry with limited choices and less than $40 billion in assets under management (AUM). It now features an estimated 10,000 offerings (no one knows the exact number) that manage more than $2.4 trillion in client assets. That still pales in comparison to the approximately $26.8 trillion in mutual fund assets, but it's an astonishing growth trajectory in not only market share but also mindshare. Mutual fund executives are considerably more concerned about the encroachment of the alternative investment business than vice versa.