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"Exploring Solutions to the Fund Assortment Problem" Summary of Research Supported by FINRA Investor Education Foundation Grant # 2005-080 Retirement investment decisions faced by employees are becoming more daunting as employers increase the number of mutual funds they offer in their defined contribution plans such as 401k's. We conducted a series of studies to better understand ordinary investors' responses to retirement plan structures (e.g., with more or fewer funds), and to explore potential solutions to the fund assortment problem. The projects summarized in this report were carried out by a team of researchers with the support of a generous grant from the FINRA Investor Education Foundation. The studies consisted of decision simulations in which we varied the number and types of funds offered for investment in defined contribution plans. We asked nationally representative samples of adult respondents whether they would invest in such a plan, and then observed how participants allocated their dollars across the offered funds. We measured various aspects of their thought processes and their feelings about their decisions, to understand the drivers of choice behavior. In total, over 2,000 respondents took part in the decision simulations. We also looked at ways to counteract the potentially negative effects of large fund assortments on choice. And we explored whether certain segments of the population, such as those with less investing expertise, those with particular thinking styles, or women, are more susceptible to plan structure effects, and whether they are more or less responsive to potential solutions. The results of the studies are organized into the following five sections, each of which is summarized on subsequent pages: Naïve Diversification Investor Expertise Gender and Decision Aids Thinking Style Hope For More Information Please Contact: Maureen Morrin Rutgers University School of Business 227 Penn St. Camden, NJ 08102 Email: mmorrin@rutgers.edu Phone: 856-225-6713 1

Does the number of funds offered in 401(k) plans affect how many funds you choose to invest in or how you spread your dollars across your chosen funds and asset classes? If so, are there ways to structure 401k plans to help offset these systematic effects? NAÏVE DIVERSIFICATION In this project we report findings from four studies conducted among adults, in which the structure of 401k plans, such as the number of funds offered, is manipulated. We were interested in how offering more or fewer mutual funds for investment would alter the way individuals invested their money across the funds offered. We found that offering very few funds for investment (e.g., 3 funds) caused many individuals to select all of the available funds for investment because most want to invest in a handful of funds in order to feel adequately diversified. THE MANAGER'S DILEMMA Investors say they prefer choosing from larger fund assortments in 401k plans. Yet larger fund assortments can be cognitively depleting and result in the use of naïve diversification strategies. How can employers offer their employees 401k plans that are preferred but that are not overwhelming or result in biased decision making behavior? Study 1 6 5 4.97 No. Funds Invested In 4 3 2 2.28 4.05 1 0 3 Fund Assortment 9 Fund Assortment 21 Fund Assortment 2

Studies 1 to 3 75.3% 81.9% % Invested in Stocks 31.0% 41.5% 55.1% 47.0% 55.1% Study 1: 3 Fund Asst Study 1: 9 Fund Asst Study 1: 21 Fund Asst Study 2: 3 Fund Asst Study 2: 15 Fund Asst Study 3: 5 Fund Asst Study 3: 25 Fund Asst Offering more funds for investment (e.g., 21 to 25) caused many investors to simply divvy up their dollars evenly across the chosen funds rather than thinking more carefully about risk and return tradeoffs. We found that offering more funds also results in other systematic effects: such as more funds being chosen, and a marked shift of dollars from bonds to stocks. However, presenting the funds in clearly defined categories, such as by asset class (e.g., stocks versus bonds), helped to significantly alleviate some of the systematic effects of fund assortment size. POTENTIAL SOLUTION Clearly categorizing the funds offered for investment will remind investors of the importance of including different types of funds on the basis of asset class membership, rather than just investing in more similar types of funds in a naïve attempt to diversify their portfolios based on the sheer number of funds chosen for investment. FOR MORE INFORMATION Morrin, Maureen, Jeffrey Inman and Susan Broniarczyk (working paper) "Decomposing the 1/n Heuristic: The Moderating Effects of Fund Assortment Size," Rutgers University. Contact: Maureen Morrin (Email: mmorrin@rutgers.edu) 3

Individuals vary in the degree to which they possess investing knowledge and expertise. Does your your level of expertise impact the degree to which larger fund assortments impact your asset allocations? INVESTOR EXPERTISE In this project we varied the number of mutual funds offered for investment: we offered participants either 3 or 21 funds to choose from in a 401k plan. We also measured self-reported investing knowledge or expertise and then classified respondents as "experts" or "novices." We found that investor expertise moderated the tendency to shift assets from bonds to stocks when choosing from a larger fund assortment. Specifically, novice investors were much more likely to exhibit this tendency. 100% 80% 60% 40% 20% Percent Invested in Stock Funds 0.29 0.61 0.60 0.66 Novices Experts POTENTIAL SOLUTION If novice investors are encouraged to consider their risk propensity and goals before making fund choices, then the 401k plan's structure, such as the number of stock funds offered for investment, may be less likely to bias their asset allocation. Novice investors should be encouraged to decide the approximate proportion of dollars they want to invest in each asset class, such as stocks and bonds, before being exposed to the set of funds offered for investment in retirement plans such as 401k's. 0% Small Fund Assortment Large Fund Assortment FOR MORE INFORMATION Morrin, Maureen, Susan Broniarczyk, Jeffrey Inman and John Broussard (working paper) "Saving for Retirement: Fund Assortment Effects on Asset Allocation Strategies of Novice versus Expert Investors" Rutgers University. Contact: Maureen Morrin (Email: mmorrin@rutgers.edu) 4

How do men and women differ in their retirement investing behavior? Decision aids such as Morningstar boxes and stars are often provided to help investors make better investment decisions. Are men or women more likely to rely on such aids? Can the decision aids reduce the gender differences ordinarily observed in the investing domain? GENDER AND DECISION AIDS In this project we look at differences between men and women in terms of their retirement investing behavior. We also look at the effects of decision aids (e.g., Morningstar boxes and stars) on investing behavior. We are interested, for example, in whether such aids are more likely to impact men's or women's investing patterns. We found that women invest less money and are more risk averse than are men, in accord with prior research. However, women are also more likely to alter their investing patterns when decision aids are present, than are men. GENDER DIFFERENCES Women differ from men in that that they invest less money in a 401k plan, controlling for a number of demographic variables, and often invest a smaller proportion in higher risk/return options such as stocks. Such differences may make it less likely that women will have sufficient funds for a secure retirement. Study 1 0.4 0.35 0.341 Percent Invested in 5 Star Funds 0.3 0.25 0.2 0.15 0.1 0.05 0.168 0.276 0.147 No Stars Stars 0 Men Gender Women 5

Goal Clarity Scale Items I already know exactly what I want to accomplish with this 401k investment decision. Even before seeing what funds are available in this 401k plan, I have a good idea of the type(s) of funds I will choose. I know just what my goals are for this 401k investment task. We explored some potential explanations for these effects, such as the degree to which individuals are confident they can achieve their objectives; the degree to which individuals resist attempts to curtail their freedoms or tell them what to do; the degree to which individuals carefully process the information provided to them before making their decisions, and the degree to which individuals possess clear goals for the investing task. What we found is that men and women differ significantly in goal clarity, with men knowing much more clearly just what they want to accomplish in the task, compared to women. Men were also more confident, more satisfied, and found the decision easier to make than women. POTENTIAL SOLUTION Women differ from men in that they are less clear about what their investment goals are, before making their decisions. Women should be educated about how to approach the investment task in terms of overall investment objectives (such as asset allocations, etc.). Clarifying the investor's objectives may help to alleviate differences between men and women in terms of decision difficulty, confidence, and satisfaction. FOR MORE INFORMATION Morrin, Maureen, Susan Broniarczyk, and J. Jeffrey Inman (working paper) "The Impact of Decision Aids on Investor Behavior: The Moderating Effect of Gender" Rutgers University. Contact: Maureen Morrin (Email: mmorrin@rutgers.edu) 6

Individuals vary in their thinking style, or the degree to which they consider both the positive and negative potential consequences of their decisions. Does your thinking style impact the degree to which decision aids impact your investment choices? THINKING STYLE In this project we explore whether individuals' thinking styles impact whether or not information presentation format affects the degree to which they diversify their portfolio. The thinking style we are interested in is the tendency to elaborate on potential outcomes. Individuals who score high on this scale tend to think about both the positive and negative consequences of their actions before making decisions. Those who score low instead tend to think of only the upsides or only the downsides of their decision. Example of Morningstar Box We wondered what impact a decision aid, such as the Morningstar box, would have on individuals with different thinking styles. The Morningstar box, which classifies funds according to two dimensions (e.g., stock funds are classified according to capitalization size and investing style), may help investors understand how mutual funds differ and thus may help them to construct more diversified portfolios. 7

Thinking Style Scale Items Before I act I consider what I will gain or lose in the future as a result of my actions. I try to anticipate as many consequences of my actions as I can. Before I make a decision I consider all possible outcomes. I always try to assess how important thee potential consequences of my decisions might be. I try hard to predict how likely different consequences are. Usually I carefully estimate the risk of various outcomes occurring. We found that investors who tended to consider both the positive and negative consequences of their decisions did not alter their portfolio diversification levels when presented with fund information graphically (i.e., via Morningstar boxes) versus textually. However, investors who ordinarily do not think about both the upsides and downsides of their decisions, created more diversified portfolios when provided fund information via the Morningstar box visual. POTENTIAL SOLUTION Investors who tend to be overly optimistic, or look on the bright side of the potential outcomes of their decisions, as well as those who tend to be overly pessimistic, may be more impacted by visually presented fund information (e.g., Morningstar boxes). They may benefit more in terms of decision aids enhancing their investment decisions. FOR MORE INFORMATION Nenkov, Gergana Y., J. Jeffrey Inman, John Hulland, and Maureen Morrin (working paper) "Moderators of the Susceptibility to Descriptive Variance Effects in Investment Decision Making," Boston College. Contact: Gergana Yordanova (Email: gergana.nenkov@bc.edu) 8

Individuals vary in the degree to which they are hopeful about their prospects for a secure retirement. How do individuals with more or less hope differ in terms of their retirement investing behavior? Moreover, do they respond differently to messages that suggest most [or few] Americans are saving enough for a financially secure retirement? HOPE In this project we look at the effects of hope on investing for retirement. We see how individuals' levels of hope impact retirement investing behavior and also look at how more hopeful versus less hopeful messages about the likelihood of achieving a financially secure retirement impact individuals' investment behavior. Message Manipulation Excerpts Less Hopeful Message: "Many experts now agree that Americans are doing an even worse job of saving for retirement than the industry typically proclaims." "It is generally recommended that one needs to build a nest egg big enough to replace 80% of one's pre-retirement income. A recent report issued by the Center for Retirement Research reveals that a significant number of Americans WILL NOT reach this figure. Thus many Americans will not be able to maintain their customary standard of living throughout retirement." " Furthermore, in the future, Social Security is not likely to be adequately funded." More Hopeful Message: "Many experts now agree that Americans are doing a better job of saving for retirement than the industry typically proclaims " "It is generally recommended that one needs to build a nest egg big enough to replace 80% of their pre-retirement income. A recent report issued by the Center for Retirement Research reveals that significant number of Americans WILL reach this figure." "Furthermore, in the future, Social Security is likely to be adequately funded." 9

Preliminary analysis suggests that those with lower levels of hope often respond more positively to the more hopeful message, whereas those with higher levels of hope often respond more positively to the less hopeful message. POTENTIAL SOLUTION The dire reports of inadequate saving by Americans for retirement may sometimes have "backfire" effects on individuals' efforts to save, especially among those who possess lower levels of hope that they will be able to accomplish this task. The tone of messages may need to be tailored according to individuals' hope levels to be most effective in the marketplace. FOR MORE INFORMATION Nenkov, Gergana Y., Deborah MacInnis, and Maureen Morrin, (working paper) "Hope and Investing for Retirement," Boston College. Contact: Gergana Y. Nenkov (Email: yordanov@bc.edu) 10