The best piece of investment advice you might ever get is to re-sort the list of investment options for your 401(k).
Right now the choices are probably listed alphabetically. Change to rank them by expense ratio. If you can’t do that, focus on that information as you scroll down the list.
That’s because the order of the list makes a big difference in what you choose.
To find out how much of a difference, Ipsos, a market research firm, teamed with Jennifer Itzkowitz, a professor at Seton Hall University’s Stillman School of Business; Thomas Doellman, a professor at Saint Louis University; and Sabuhi Sardarli, a professor at Kansas State University. The team analyzed fund-choice data from nearly 7,000 companies that covers hundreds of thousands of individual investment decisions. The results, which should appear in the peer-reviewed Financial Review later this year, are striking.
When a fund moves up 10 positions on a list, there is a 20% increase in fund investment.
As humans, we have a tendency to read down a list until we find an option that seems suitable and then select it. It’s true on long lists, but it’s even true on short lists. Studies have shown that stocks that come first in the alphabet trade more often than those later in the alphabet — even when you control for high-volume Apple and Amazon.
However, time and again behavioral science shows that humans don’t behave rationally. In this case, they are “satisficing” or finding the first choice in the list that satisfies their criteria. It’s a lazy way of making such an important life choice, to be sure. But it’s also human nature.
The alphabet, however, isn’t a good predictor of fund performance. If companies listed their fund choices by expenses instead of alphabetically, investors could wind up with an additional $20,440 in retirement savings. That benefit is calculated based on a $5,000 per year investment at a fixed 7% annual gross rate of return over 30 years. Clearly for those who save more of their income, the benefits could be much higher.
To be sure, expenses don’t predict fund performance either. But low-fund fees tend to track indexes, and stock-picking fund managers on average tend to both cost more and deliver below-market returns. If two funds perform equally well, the fund with a lower expense ratio, rather than which comes first alphabetically, is the better choice.
The average expense ratio of the first four funds when listed alphabetically in our study was 90 basis points, or nearly 1% of the assets under management. The average expenses of the first four funds ranked by expense ratio from lowest to highest was 62 basis points. So if you were to invest equally in the four funds with the lowest expense ratios rather than the first four funds when listed alphabetically, you would pay an average of 31% (28 basis points) less in expenses.
In other words, a fairly simple change by your benefits department could put more money in your wallet during retirement. It could buy you several nice retirement vacations, or pay your mortgage for months or cover some medical bills.
Unfortunately, this isn’t something benefit departments and 401(k) plan administrators do. Employees should push for this for the sake of their retirement savings.
Successful mutual fund managers should be lobbying for the change as well. Take a hypothetical fund with $32.5 million in assets under management, the average amount for funds in our study. A low-alphabet, high-performance fund who could move up 10 slots on the list would see increased investment in the fund of $653,000, assuming all other things being equal, according to our statistical analysis
Unfortunately, conferring with a financial adviser doesn’t necessarily avoid this behavior trap. People who work for financial services companies also tend to pick the first funds that meet their criteria, according to our research.
Back in the days of phone books, companies intuitively understood that being listed first mattered. That’s why you had so many AAA carpet cleaners and ACME widget makers. Choosing the wrong carpet cleaner shouldn’t be a huge life-changing decision, but choosing the wrong investments certainly could be.
