Morningstar Magazine - June/July 2018 - 24

Dispatches

3,622 participants. In the experiment, we asked
participants to allocate a hypothetical $10,000
across three real S&P 500 ETF index funds
(with pseudonyms). As noted above, the funds
were indistinguishable except for their
expense ratios. To understand how investors might
select investments, we tested different ways
to present the options, drawing on ongoing
debates in the policy and industry arenas. Some
participants were randomly assigned to see
fees in terms of current dollar cost or in terms
of percentages. The study also varied the
format of the performance: Either bar charts
showing prospectus-style year-by-year returns
or a line graph showing the historical growth
of $10,000 were displayed.

Our results suggest that changing how fees
and performance are displayed did not help people
choose the most cost-effective option. In fact,
on average, only 14% of the participants put all of
their money in the cheapest option and did so
regardless of how the fees and performance were
displayed. However, we found that modifying
how selections were made-i.e., whether
investors faced multiple choices in how to allocate
their money-did drive down unnecessary
spending on higher-fee funds.
Diversification Efforts Can Backfire

We also randomly assigned the type of investment
decision that investors faced. Half of the
participants could choose only one ETF to allocate
all of their funds to. The other half were free
to allocate the $10,000 in any manner across all
three options. By comparing the average
allocation decisions between both groups, we can
identify why people might choose higherpriced investments, even though there are cheaper,
essentially identical alternatives available.
In both situations (choose only one or choose
allocating freely among many funds), the optimal
decision is to allocate all resources to the
cheapest option. Some participants did not follow
this logic, however. On average, participants
who were asked to allocate freely across all three

options allocated 27% of their funds to the
most expensive ETF, 31% to the middle ETF, and
42% of their funds to the cheapest, which indicates
that people were diversifying across all options.

show that when faced with multiple options do
investors invest in suboptimal funds, but the fees
they incur directly undercut their returns.
How to Present Fees to Retail Investors

In contrast, when participants were restricted
to allocate all of their money to only one fund,
people invested significantly more in the cheapest
ETF: About 47% chose this option when
constrained to make one choice, versus 13.7%
choosing to place all of their funds in the
cheapest option when they were not constrained.
The proportion of funds allocated to the
most expensive fund fell to about 20%. This
demonstrates that price sensitivity can be
increased and that multiple options may distract
people from a purely economic assessment
of the best investment for their funds.

Our study suggests that naïve diversification may
be costing investors additional fees by inducing
them to make suboptimal investing decisions. Fund
companies will likely continue to offer equivalent
funds at disparate prices, and proposed
changes to fee disclosure (like dollar-valued fees)
don't appear to be effective on their own. But the
financial industry can help investors avoid
this decision-making mistake in other ways: by
curating out higher-priced but otherwise similar
options and leaving a set of investments
that are structured to yield good portfolios even
if investors uniformly spread their money among
the available alternatives.

Paying for Choice

These results suggest that participants were
resorting to a decision-making shortcut
called "naïve diversification."3 In an attempt to
spread out risk and avoid making the wrong choice,
participants essentially followed the popular
mantra, "Don't put all your eggs in one basket."
This strategy can be triggered by choice overload,
a cognitive phenomenon linked to the complexity
of a decision-making context. Unfortunately
for individuals, investment decisions are a perfect
example of such a context. Investment decisions
come with the cognitive difficulty stemming
from risking hard-earned money, technical jargon,
calculations that many individuals find
daunting, and an inordinate amount of information
and alternatives that add to the complexity.
It's only natural for individuals to resort to a
shortcut like naïve diversification and allocate their
money somewhat evenly across all available
options,4 even ones that are overpriced.
The data shows that those who resorted to naïve
diversification, on average, paid about four
times more in fees, even though all three ETFs are
indistinguishable in terms of performance
and portfolio holdings. Not only do our results

What This Means for the Industry

When left to their own devices, a substantial
number of people do not make optimal
choices with respect to costs. An important
takeaway from these experiments is the
importance of the investment decision ecosystem.
The typical investor does not make investment
decisions in a vacuum. He or she engages
with intermediaries such as advisors, regulators
such as the SEC, and financial research companies
such as Morningstar.
As evidenced by our experiment, relying on fees
alone as a market differentiator may not be
enough to attract investors. Transparency and
lowering fees are necessary but, ultimately,
insufficient. Advisors and fund providers can tailor
the choice environment to help real people
make smart decisions, even when they feel hurried,
overwhelmed, and unsure. K.
Stephen Wendel, Ph.D., is head of behavioral science
with Morningstar.
Ray Sin, Ph.D., behavioral scientist, behavioral science,
with Morningstar, and Ryan O. Murphy, Ph.D., head of
decision sciences with Morningstar Investment
Management, contributed to this article

3 Benartzi, S., & Thaler, R.H. 2001. "Naïve Diversification Strategies in Defined Contribution Saving Plans." The American Economic Review, Vol. 91, No. 1, pp. 79-98.
4 Iyengar, S., & Lepper, M.R. 2000. "When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?" Personality Processes and Individual Differences, Vol. 79, No. 6, pp. 995-1006.

Morningstar June/July 2018

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