Addressing the choice overload problem

As humans, we typically want more choices. But more choices can be confusing. It is easier to choose an active fund from 10 funds than from 100 funds. With continual entry of new asset management firms (AMCs) into the industry, the choice of mutual fund products has increased over the years. In this article, we look at why more fund choices lead to less behaviourally-optimal selection by investors.

When in doubt, we diversify. So, we can take a decision when faced with fewer fund choices, even if we are unsure of those choices. Faced with N number of choices, we simply allocate our savings equally across the N choices. Behavioural psychologists call this diversification heuristics. Now, that is optimal when the number of choices is five or less. What happens when you have 100 or more funds to choose from? The choices can be overwhelming. At the extreme, this can lead to individuals suffering from status quo basis. Unable to select funds because of the numerous choices, many individuals could keep their savings in bank deposits, unintentionally earning lower returns.

Even if you were to invest in several of these funds, there could be an issue of investment overlap. Consider this. AMFI lists several classes of funds with NSE 500 as the intended Tier 1 benchmark. Among other funds, the following can choose the NSE 500 Index: flexi-cap funds, dividend yield funds, thematic funds, momentum funds and sector rotation funds. The benchmark index is the investable universe for these funds. That is, these funds will be created out of the 500 stocks that constitute the index. You may hold a flexi-cap fund, a sector rotation fund and a dividend yield fund. Despite their different styles, your portfolio may have exposure to similar set of stocks because of the common benchmark, exposing you to high risk in the event these stock prices decline.

Is there a way to moderate issues relating to the choice overload, given that the supply of new funds in the market is unlikely to reduce? Perhaps, it is best to group all funds based on their benchmark regardless of their investment styles. That way, your choice can be based on benchmarks which are fewer in number compared to fund styles. Within a benchmark, individuals are likely to look at consistently top-performing funds. While the way individuals select funds may not always be optimal, the confusion from too many choices can be minimized.

(The author offers training programmes for individuals to manage their personal investments)