Analysis paralysis

The server at a fine restaurant hands you a dessert menu with three choices: cherry cheesecake, chocolate mousse or crème brûlée. They all sound delicious, but chances are you’ll have little trouble making a selection. Now imagine the menu lists 150 mouth-watering options. Suddenly your simple choice has turned into “a kind of misery-inducing tyranny,” in the words of Barry Schwartz, author of The Paradox of Choice. No matter which treat you choose, you’ll be left wondering whether one of the other 149 choices would have been better. You may even decide to skip dessert altogether because, as Schwartz writes, “unconstrained freedom leads to paralysis.”

We all love choices. But whether it’s desserts or mutual funds, a huge number of options often leads to worse decisions and lower satisfaction. In one study commissioned by the investment firm Vanguard, researchers found 75% of employees enrolled in their workplace retirement plans when they had just four funds to choose from, but only 60% did so when they had 59 options. Many employees who were overwhelmed by choice did nothing. A host of others simply picked the most conservative choices (bond or money market funds) rather than making any attempt to learn about the funds with more potential for growth.

The psychological culprit here is called regret aversion: people tend to put off making decisions because they fear their choice will lead to a poor outcome. It often leads investors to sit on large amounts of cash, especially after they have sold at a loss. At other times it reveals itself as plain old procrastination. “Among people who are managing their own portfolios, or who are controlling the decisions of their advisers, there is a tendency to procrastinate everything from making monthly contributions to rebalancing properly,” says Keith Matthews, portfolio manager at Tulett, Matthews & Associates in Montreal and author of The Empowered Investor.

You can overcome analysis paralysis by automating many decisions: setting up preauthorized monthly contributions is an ideal way to avoid the stress of investing lump sums. For very large amounts (such as the proceeds from selling a business) Matthews sometimes eases into the market to reduce the risk of bad timing, but he’ll do so over just nine to 12 months. “Think about making a few big steps,” he says, “because if you’re doing a lot of little steps, somewhere along the way something is going to spook you and you’re going to stop.”

Framing

I recently spoke with an investor I’ll call Monique who was upset that her adviser had bought two speculative mining stocks that had since lost half their value. I asked why she didn’t just dump them, especially since she was a conservative investor who felt they were completely inappropriate. “Because I want to wait for them to get back to even before I sell,” she said. I then asked her whether she’d expect to double her money if she bought more shares. She thought I was crazy.

My chat with Monique provided a classic example of what psychologists call framing. When the same choice is presented in different ways, people often make opposite decisions. Monique framed her decision like this: “Should I sell my stocks with a huge loss or wait for them to fully recover?” When phrased like that, the decision to hold on sounds appealing. In contrast, my suggestion made me sound like a reckless gambler. But if Monique expected her stocks to get “back to even” after being cut in half, she was banking on a 100% return. The questions are the same: the only difference is how they’re framed.

Understanding the framing effect is also important when you’re investing a large lump sum. Imagine you received a $100,000 cash inheritance and are nervous about investing it because you feel stocks are overvalued and bonds will suffer if interest rates rise. Would you invest the whole amount immediately or ease into the market a little at a time? Now flip the question around and imagine you instead inherited a $100,000 portfolio of stocks and bonds. Would you immediately sell everything and reinvest the proceeds gradually? Ignoring taxes and transactions costs, this is the same decision framed in two different ways, yet most people would likely answer yes to the first and no to the second.