When I first took up running, I went into the store, looked at a wall of specialty shoes- stability, control, neutral cushioned, performance etc. etc.- and just blanked out. Were my feet so screwed up that I needed a special shoe? What if I bought these specialized shoes, at a whooping cost of $200, and didn’t like it? Why did I even need special shoes having run most of my life in “normal” footwear? Suffice to say, my feet may not have needed special shoes but my psyche just added a complex.

The conventional wisdom is that choice is good. It is empowering and gives the consumer a sense of control. But, in a universe where there are more mutual funds and exchange traded funds than publicly listed companies, can too much product choice actually be ruining our finances?

I tackle this issue in two separate posts. Today’s post deals with the larger issues with too many choices. Tomorrow’s post will deal with the result from an asset allocation and portfolio management perspective.

The study of the psychological effects of choice came to popular attention at the height of the dot com boom. In 2000, Barry Schwartz coined the term the paradox of choice (which he subsequently turned into the title of his 2004 book). In essence, the more choice a customer is given, the greater the expectation of return and the anticipation of regret that return will not meet expectations. If given more choice, the consumer has a more difficult time making a choice and such difficulty results in anxiety, sadness and, in some cases, depression. In other words, the opposite effect of what freedom of choice is supposed to give you.

Too much choice typically manifests itself in several ways. The first is analysis paralysis: the sheer amount of information overwhelms one’s ability to make a decision. A second is regret by focusing too much on missed opportunities rather than a focus on the potential of the choice made. The third is anxiety; being forced to make a decision is stressful for some.

In the personal finance realm, too much product choice tends to display itself in several behaviors:

1. Not investing at all. There has been a lot of criticism about the retail investor missing the rise of equities in 2009. Some of this inaction is attributed to fear but how much of this can be attributed to too much choice? In a 24-7 world of business news- all with their own experts touting their own hot investment product- how is any average investor to decipher all of this noise? The natural reaction may be to simply turtle- climb in one’s shell and do nothing.
2. Choice leads to declining participation rates. Vanguard Group found that 75% of employees participated in a 401(k) plan when 2 fund choices were presented. When the number rose to 10 choices, participation slipped to 70%. At over 60 fund choices, participation rates begin to decline steadily (if you think 60 fund choices is too much, consider that Ford Motor Company had over 120 fund choices in its 401(k) program at one point in time).
3. Poor execution of an investment strategy. I will address this issue tomorrow.

If too little choice and too much choice is bad, what exactly is the optimal amount of choice a person should have? A Dutch research paper suggested anywhere between 12- 24 choices produced the optimal balance between variety and happiness.

How does the average investor cope with an industry that works in quantity if not necessarily quality?

1. Set your goals first before looking at product. Choice selection is made easy if you set a goal. If your financial goal is not to lose money and to be conservative, you have automatically eliminated all high risk/high reward products.
2. Limit the information given to you based on your goal. It is easy to get off-track on your goals given the amount of information coming at you. In marketing lingo, every good marketer has a “call to action” to every marketing piece. Most calls to action are to buy (watch the “I buy your gold” commercials; despite the high cheese factor, they are brilliant at manipulating us).  By limiting calls to action, you limit the industry’s ability to reach out and distract you from your goal.
3. Pick the product sub-set that aligns with your goals the best. This is pretty self-explanatory.

Tomorrow, I will tackle asset allocation in a world with too much choice.