Beware of “alphabetical Bias” When Choosing Investments
You already know that many of your financial decisions are not rationally made: prejudice bias, sunk cost error, and mental accounting all play an important role in how we spend, save, and think about our money. The new report adds a new bias to be aware of when choosing an investment.
The Alphabetical Bias in 401 (k) Investments report found that the order in which funds are listed (usually in alphabetical order) “significantly influences participants’ investment allocation decisions.” Bias is more pronounced when there are more fund options, but it is also present when “relatively little” funds are available.
According to the report, the options listed first are chosen more often because two psychological processes work in tandem: status quo bias and satisfaction .
The addiction to the status quo comes into play because while investors can change the order of their investment options, they usually don’t and “rely on the default list, which is in alphabetical order. They then stop looking for funds when they find the first “acceptable” option, no matter how many options are left to go through, which is also called satisfactory .
“As such, when a member scrolls through a menu of investment options for their plan, they are more likely to choose the funds that appear at the top of the list,” the report says. “Since 401 (k) selection pools with early alphabetic names appear at the top of the list, they will be selected more frequently than later alphabetic collections.”
This bias is common in any number of decisions, says Humble Dollar’s Adam Grossman, in both financial and non-financial decisions. But when it comes to your 401 (k), you can lose thousands of dollars. As Grossman writes:
Two high-value fund companies – American Funds and American Century – are at the top of most lists, while the low-cost leader Vanguard Group usually ends up near the end.
When choosing funds for your portfolio, keep in mind, among other things, cost, commissions , diversification, and efficiency . Most importantly, order the cost-benefit options provided to you. This can help you make a better investment decision.