Get to Know You
October 26, 2002
The genius of capitalism is meeting and creating consumer needs and wants. Our grandparents didn't have anywhere near the number of goods most Americans can buy by visiting a Home Depot, a Target, a grocery store, or shopping mall. Most of us don't want to go back in time. We're glad to have plenty of choice.
Still, is more choice always a good thing? Charlie Trotter's is tops among Chicago's restaurants and New York's Peter Lugar's is one of the best steakhouses in the country. Yet customers can only choose between two tasting menus at Trotter's, and don't bother to dine at Lugar's if you don't like steak. Anybody trying to choose a cell phone plan is easily overwhelmed by the vast menu of services and pricing plans.
Investors may have too much choice in their retirement savings plans. That's the conclusion of recent research by behavioral economists Shlomo Benartzi from UCLA Richard Thaler of the University of Chicago. A decade ago, most 401(k) plans offered a handful of mutual funds, say, an equity fund, a bond fund, a money market fund, and company stock. In recent years, plan sponsors souped up their 401(k)s with 50, 100, 200 funds. Many companies even added a brokerage option for trading individual securities.
The problem is that workers, the supposed beneficiaries of ever more retirement savings options, may well be worse off. Who hasn't been confused trying to figure out which of 10 large-cap stock funds to pick in their 401(k), let alone what percentage of contributions to allocate to stocks and bonds? Little wonder workers turn to their colleagues for advice. Or they may rely on investment maxims, such as subtracting your age from 100 to decide on the right percentage of equities in your retirement portfolio. If you're 50, that would mean 50 percent equity and 50 percent bonds. Yet this simplistic rule only takes age into account and not other important factors, such as a willingness to tolerate risk and job security.
The nub of the issue is that workers are human. Okay, that sounds silly so baldly stated. But Daniel Kahneman of Princeton University just got one-half of the Nobel Prize in economics making that point. Kahneman, a pioneer in the field of behavioral economics, devised a number of ingenious experiments showing how investors and consumers are intensely human everyday, over-confident at times, fearful at others, coping with complexity with rules of thumb, befuddled by their choices in an uncertain world. People are far from the coolly rational, risk calculating, knowledgeable homo economicus favored by mainstream economists.
The insights of behavioral economists are more than just a passing curiosity. An awareness of how much all of us rely on rules of thumb, the tug of emotions, and a cognitive preference for the middle course can make us a better investor. An added bonus: Self-knowledge will help you stay focused on long-term financial planning and your own best interests.
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