Don’t Let Alphabeticity Bias Cloud Your 401(k) Investment Selection

February 26, 2019  |  

Don’t Let Alphabeticity Bias Cloud Your 401(k) Investment Selection

We have written in the past about many of the behavioral biases that cause investors to sway from their wealth building plans. Survivorship Bias, Recency Bias, Confirmation Bias and Herd Mentality are just a few of the common tricks our brains play on us when it comes to making sound investment and retirement planning decisions.

Alphabeticity Bias

A recent study found that the order in which funds are listed in employer defined contributions plans (401(k)s, 403(b)s, etc.)  affects how often employees select them while creating their portfolio. According to this new multi-university study, funds listed at the top of the list–i.e. based on alphabetical order–are more likely to be chosen than funds lower down the list, regardless of suitability, expense or performance.

Researchers also found that Alphabeticity Bias is more pronounced when there are a larger number of fund options, but it’s also present when there are “relatively few” funds to choose from. Researchers believe Alphabeticity Bias is the result of two powerful psychological forces working simultaneously:

1.  Status quo bias

2.  Satisficing.

Status quo bias plays a part in clouding decisions because investors typically don’t take the time to reorder investment choices in their heads and “rely on the default list (which is alphabetical),” the study concluded.

Satisficing comes into play when investors stop looking through funds as soon as they find the first satisfactory—not necessarily ideal–option, regardless of however many other choices are left.  

 “Since 401(k) fund choices with early alphabet names appear at the beginning of the list, they will be chosen more often than later alphabet named funds,” researchers added.

The findings of this Alphabeticity study are intriguing on many levels. If participants fall victim to this newfound bias, chances are they are not optimizing their retirement portfolios.  It is hard to pinpoint the errors that could arise, mainly because every 401(k) plan has different investment options available to their participants.  Hypothetically speaking however, Alphabeticity bias could lead participants to select investment options with higher internal costs and build a portfolio that is not globally diversified – simply because of how the investment options are listed.

History shows the enrollment process for a new participant in a new 401(k) is not very “robust.”  Also, when starting a new job, enrolling in a 401k plan (let alone analyzing and selecting the investment options) is not at the top of the priority list for many overwhelmed new employees. These factors – bias, system and environment – result in minor missteps which can snowball over time and hinder an employee’s ability to optimize their retirement portfolio today and into the future.

Conclusion

Your 401(k) (or other retirement savings plan) is a critical part of your comprehensive financial and wealth building plan. Taking a little extra time to do your homework on your retirement options can pay big dividends in the future. Don’t let Alphabeticity or other behavioral biases throw speed bumps in the way of a smooth road to retirement.

If you have any questions about your new or current 401k portfolio, please do not hesitate to reach out to us.

 

Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience.  Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.  Diversification does not eliminate the risk of market loss an A long-term investment approach cannot guarantee a profit.

 


About Patrick Melvin Jr.

Patrick D. Melvin Jr., is a Wealth Manager at Independence Advisors, LLC. Pat models client’s financial plans and works with the firm’s clients on financial planning areas such as retirement planning, investment planning and estate planning. CLICK HERE TO ASK PAT.
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