Having Choice and Guidance Isn’t Always a Good Thing
by Charles Rotblut | February 16, 2017
There is rarely a week that goes by without a new fund being launched. There is also rarely a day when someone does not recommend a stock or a bond. It’s enough to make an investor’s head spin. It certainly complicates the process of choosing a good investment and sticking to a long-term investment strategy.
The problem is not limited to just the broad array of investment recommendations. Even if all you want to do is buy an index fund designed to track the performance and volatility of the S&P 500, you will have to choose from at least 14 mutual funds and exchange-traded funds. (I’ll have more to say about S&P 500 index funds in next month’s AAII Journal.)
While people like having choices, too many options makes settling on one specific choice difficult. There is a technical term to describe this problem: the excessive choice effect (ECE). The ECE refers to the inverse relationship between the number of options and the ability of a person to make a choice. It is most famously related to a study involving jam. Authors Sheena Iyengar and Mark Lepper found that consumers more likely to purchase jam when presented with six choices than when they were presented with 24 choices.
Our brains perceive choice paradoxically. We like having lots of options to choose from. At the same time, we fret about making the wrong decision. Obviously, the consequences of selecting the wrong jam are minor. The consequences of selecting the wrong security or fund can be far more significant.
One way to reduce the influence of the excessive choice effect is to have useful guidance available at the time the decision is being made. A new study about craft beer demonstrated this. (Any study combining behavioral economics with beer is likely to pique my interest.) Sales declined when the number of beers listed on the menu were increased from six to 12. The inclusion of BeerAdvocate scores (a rating system based on both user and critic reviews) boosted sales both when six and 12 beers were listed on the menu, however.
Depending on what is being chosen, merely having available guidance at the time the decision is being made may not be enough to prevent experiencing regret about the decision. The guidance itself matters too. Getting errant advice from BeerAdvocate is easily fixable—you simply order a different beer. Getting errant advice from a financial adviser or advisory service can be much more problematic. An advisor can narrow down the options for annuities, for instance, but if the guidance steers you to a high-cost contract, then you’ll still end up feeling regret about the choice you made. Similarly, if a mutual fund rating system leads you to buy a fund that underperforms in the future, you’ll wish you had selected a different fund.
The middle ground is to have a set list of criteria or rules for making a decision. For investing, it starts with the allocation process (e.g., do I need stocks or bonds?) and narrows down from there. A checklist of characteristics to look for helps out greatly here for making comparisons. For funds, the list could include year-by-year returns against the fund’s peers, the expense ratio, tax efficiency, manager tenure, etc. For stocks, it could be valuation, profitability, yield, etc. For bonds, it could be credit rating, tax treatment, financial strength of the issuer, etc. The general idea is to have a yardstick to judge the attractiveness of an investment. This will help to narrow the down the list of candidates to those you find most attractive.
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Setting Up and Managing Your 401(k) – Retirement plan options are often given without any guidance about how to pick a fund; here are tips for making the right decisions for your 401(k) plan.
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Defining Your Investment Philosophy – Knowing how you want to invest can make choosing investments easier.
The percentage of individual investors describing their short-term market outlook as “bearish” rose over the last week, while optimism pulled back, according to the latest AAII Sentiment Survey. This change has now pushed the bull-bear spread (bullish sentiment minus bearish sentiment) to 0.7%, its tightest range since August 24, 2016.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.7 percentage points to 33.1%. Optimism was last lower on February 1, 2017 (32.8%). The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 2.0 percentage points to 34.5%. Neutral sentiment was last lower on February 1, 2017 (33.0%), though neutral sentiment has been above its historical average for four consecutive weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.7 percentage points to 32.4%. Pessimism was last higher on February 1, 2017 (34.1%). This week’s gain now puts bearish sentiment back above its historical average of 30.5%.
Since starting 2017 at 46.2%, bullish sentiment has pulled back by a cumulative 13.1 percentage points. Over the same period, neutral sentiment and bearish sentiment have risen by 5.9 and 7.2 percentage points, respectively. (The numbers are rounded.) All three of the indicators remain within their typical historical ranges.
U.S. markets pulled back slightly on Thursday, pausing after posting a series of records. The S&P 500 rose seven sessions through Wednesday and has closed at new highs eight times in 2017. The week was off to a good start after the Commerce Department reported stronger-than-expected growth in retail sales in January and the Federal Reserve reported factory output increased last month. Additionally, the Labor Department said that a gauge of U.S. inflation rose to its highest annual level in nearly five years.
Federal Reserve Chair Janet Yellen spoke this week, stating that the central bank may raise rates at its upcoming meeting. Following Yellen’s congressional testimony on Tuesday, Fed-funds futures tracked by CME Group signaled a 22% chance that the Federal Reserve may raise rates at the next meeting on March 15, 2017, almost double the probability before Janet Yellen’s statements.
This week’s special question asked AAII members about the most important qualities/characteristics they look for in a stock they wish to buy, and why. Roughly 22% of respondents said that they look for an attractive dividend yield or an increasing dividend payment. Approximately 12% of respondents said that they look for strong earnings growth, while 9% look for a low P/E ratio compared to historical averages. Most members mentioned several items at a time. Other factors considered included positive momentum, a strong balance sheet, solid revenue growth, strong cash flow, and analyst ratings and recommendations.
Here is a sampling of the responses:
- “Consistently increasing dividend over 12 years, earnings positive past 3 years and forecasted growth in the future, P/E ratio of 13.0 or less, continuous innovation and a payout ratio of 60% or less.”
- “Industry or sector, quality of the company and its financials (moat effect), P/E ratio, dividend yield, and other factors like debt, free cash flow, balance sheet strength, growth rates and price-to-sales (P/S) ratio.”
- “Low P/E ratio and a dividend yield of at least 3%.”
- “Large value stocks with a long history of raising dividends. In market downturns, stocks with good dividends improve overall return.”
- “Revenue and earnings growth.”
- “Low P/E ratio, price momentum and earnings growth.”
Bullish: 33.1%, down 2.7 points
Neutral: 34.5%, down 2.0 points
Bearish: 32.4%, up 4.7 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
February 9, 2017 How I Choose a Stock to Buy or Sell
February 2, 2017 How I Analyze Earnings Releases
January 26, 2017 Putting Dow 20,000 Into Context
January 19, 2017 Know When to Sell Before You Have To
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