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. But 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, they give more). And consumers do this too, which is why companies favor names like Acme.
In this case, researchers wanted to find out whether alphabeticity also impacts the way people make investment decisions. They examined this question by looking at corporate 401(k) accounts, where workers typically choose from a fixed 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 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 these ten questions as you evaluate each option:
1. What type of fund is it? Most funds fall into one of three categories: (1) Target-date funds, which offer a mix of investments that automatically becomes more conservative as you get older; (2) Hybrid funds, which offer a fixed mix of investments; and (3) Single-asset-class funds, such as a pure stock fund or pure bond fund. In my view, this is the most important question since asset allocation is the single most important factor influencing a fund’s performance.
2. What’s inside it? Especially if a fund is a target-date or hybrid, you really need to understand what you’re buying. Retirement plan providers are notorious for abbreviating fund names to the point that they barely make any sense. Among the names I’ve seen: “25 To-Go” and “Interest Income Fund”. If you’re not sure, consult an independent source like morningstar.com. Simply type in the fund’s ticker symbol, 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? And is it short or long term?
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 is 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 HR department. Fees are always available in supplementary disclosures. Yes, you can 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.
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. Yes, you want to look at returns over multiple years, but be sure to look at each individual year, rather than average annual returns, which can sometimes conceal an uneven history.
7. What is the fund’s turnover ratio? When mutual fund managers trade frequently, they incur costs that are invisible to you, but very real. High quality funds will have turnover below 20%. If if it’s much more than that, I’d steer clear.
8. Is the fund mainstream? In the U.S., there are more than 22,000 mutual funds. 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 a fund’s name.
10. Who runs the fund? When in doubt, look for the Vanguard name. To be sure, Vanguard isn’t perfect, and they’re not the only high-quality provider, but most of their funds are index funds, and even their actively-managed funds carry very low price tags.
