IN THE WORLD of personal finance, researchers have long understood that behavioral biases negatively impact investors. Examples include recency bias, hindsight bias, confirmation bias and many others. These are all well documented. Recently, a group of researchers uncovered yet another investor bias: This one is called “alphabeticity bias.”
Alphabeticity, as you might guess, refers to the bias that can occur when choices are presented in alphabetical order. This bias, the researchers note, is found in a number of domains: In elections, candidates at the top of the ballot often win more votes. In fundraising, solicitors call people with A names more frequently (and, as a result, those folks give more). Consumers do this, too, which is why companies favor names like Acme.
In this case, researchers wanted to find out whether alphabeticity impacts the way people make investment decisions. They examined this question by looking at corporate 401(k) accounts, where workers typically choose from a list of 10 or 20 mutual funds.
The result: Alphabeticity strikes again. Even when it’s a short list, the data shows that workers disproportionately choose funds that appear near the top of the list. On the surface, this is unfortunate, because a fund’s position on a list shouldn’t tell you anything about the quality of the fund. But it’s doubly unfortunate for this reason: Two companies with expensive funds—American Funds and American Century—land at the top of most lists, while low-cost leader Vanguard Group usually falls near the bottom.
If you’ve been struggling to make sense of the mutual funds in your company’s 401(k), I suggest asking these 10 questions as you evaluate each option:
1. What type of fund is it? Most funds fall into one of three categories. First, there are target-date funds, which offer a mix of investments that automatically becomes more conservative as you get older. Second, there are hybrid funds, which offer a fixed mix of investments. Finally, there are single-asset-class funds, such as a pure stock fund or pure bond fund. In my view, this is the most important question to ask, since asset allocation is the single most important factor influencing a fund’s performance.
2. What’s inside it? This question is especially crucial if you’re looking at a target-date or hybrid fund. You really need to understand what you’re buying. Retirement plan providers are notorious for abbreviating fund names to the point where they barely make any sense. Among the names I’ve seen: “25 To-Go” and “Interest Income Fund.” If you aren’t sure what a fund owns, consult an independent source like Morningstar.com. Simply type in the fund’s ticker symbol and then click the “Portfolio” tab.
3. What exactly is inside it? If it’s a stock fund, is it a domestic fund or international? Does it cover the entire market or just part of it? If it’s a bond fund, does it consist of corporate bonds, government bonds, junk bonds or a mix? Does it own short-term or long-term bonds?
4. Is it an index fund or actively managed? Does the fund employ a highly paid stock-picker who is attempting to beat the market, or is it an index fund that’s simply trying to match the market at low cost?
5. What does the fund cost? In addition to inscrutable fund names, 401(k) menus are notorious for concealing the cost of each fund—known as the “expense ratio.” If you can’t find expense ratios in the documents you have, ask your human resources department. Fees are always available in supplementary disclosure materials. Yes, you can also find fee information online. But funds come in many “share classes,” each with their own pricing, so be sure to consult your own company’s documents. Favor funds that charge 0.5% a year or less—preferably much less.
6. How has the fund performed? A good index fund should deliver performance very close to its index. But if your plan offers only actively managed funds, you’ll need to evaluate its track record more carefully. Again, refer to Morningstar, but be careful. You want to look at returns over multiple years. But also be sure to look at each individual year, rather than just at average annual returns, which can sometimes conceal an uneven history—an indication that the manager’s impressive track record might be the result of one or two lucky years.
7. What is the fund’s turnover ratio? When mutual fund managers trade frequently, they incur costs that are invisible to you, but have a very real impact. Desirable funds will have turnover below 20%. If it’s much more than that, I’d steer clear.
8. Is the fund mainstream? In the U.S., there are more than 25,000 mutual funds on offer, if you add up all the various share classes, according to the Investment Company Institute. To differentiate themselves in a crowded market, fund companies often create oddball investments that are expensive and unnecessarily complex. I would keep it simple: Stick to stock and bond funds.
9. Is it narrow or broad? These days, fund companies understand that the word “index” is appealing. But beware: Not all index funds are created equal. Many indexes are very narrow and, as a result, potentially risky—a commodities fund, for example. My advice: Choose only broadly diversified index funds. Ideally, you’ll want to see words like “total market fund” in the name.
10. Who runs the fund? When in doubt, look for the Vanguard name. To be sure, Vanguard isn’t perfect and it isn’t the only high-quality provider. But many of its funds are index funds and even its actively managed funds carry very low price tags. Where can you find Vanguard’s funds? Just scroll to the bottom of that alphabetical list.
Adam M. Grossman’s previous articles include Humble Arithmetic, Repeat for Emphasis and Apple Dunking. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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