How to make better investment choices

(Money Magazine) -- Choice is powerful. It means you have the freedom to find just the right breakfast cereal, car, or mutual fund that suits you. And it means that companies have to innovate, to come up with better products that stand out from the crowd. (There would be no hybrid cars or ETFs in a world where everyone always settled for "good enough.")

But choice also overwhelms. You've felt it when you've gone out for a quick trip to the grocery store and found yourself roaming the aisles for an hour. Or when you've scratched your head over which of 16 stock funds you should hold in your 401(k).

Sheena Iyengar, a business professor at Columbia University, was among the first academics to study these real-world problems. In a series of ingenious experiments, she found that too many choices can cause people to give up and make no choice at all.

In her new book, "The Art of Choosing," Iyengar explores ways we can become better choosers. Many of her recommendations are aimed at the people who design those options, such as businesses and 401(k) administrators.

But she also has some ideas about ways you can make the best call in a world where decisions are often going to be messy. Iyengar spoke with senior writer Penelope Wang about her research; edited excerpts follow.

Why is choosing so hard?

Sometimes you'll see a picture of a gorgeous piece of furniture or a dress, and your preferences will hit you over the head -- but that's not usually the case. There are actually three separate mental tasks involved.

First, you need to know what you want, and most of the time we don't, particularly when we are presented with something new. Second, you need to be able to understand the relevant options. And then you need to make tradeoffs. This a complex exercise. And it only gets more complex when choices multiply.

You did a now-famous experiment -- the "jam study" -- that shows what happens then. How did it work?

In the late '90s, I was living in California. I got to know this up-scale supermarket, Draeger's, that had a huge array of products. They had 75 kinds of olive oil. They also had tasting booths where shoppers could sample different products, and they let me conduct a study with my own tasting booth.

My research assistants and I offered samples of a British jam. We would switch between two different assortment sizes: a large assortment of 24 flavors, and a small group of just six. More customers were attracted by the large number of samples. But we found that while 30% of the shoppers who saw the small assortment ended up buying jam, only 3% of people bought a jar after being shown the large assortment. When people had too many choices, they just walked away.

But aren't there advantages to having more choices?

Yes. Today you can easily get rare copies of books or find obscure music. But depending on the type of choice involved, it can require too much expertise to sort through all the options.

Besides coming home from the store without a jar of pricey jam, does this really matter?

I did a study with Vanguard on 401(k) enrollment, which is a more serious issue for people. It found that for every set of 10 additional fund options in a company plan, the number of employees who enrolled dropped about 2%.

When there were just two choices, 75% participated, but when there were 59, about 60% enrolled. If it's a lot of work to choose among the funds, many people will postpone the decision and never sign up.

Or look at Medicare's prescription drug benefit. When people first had to choose a plan by 2006, they were overwhelmed by too many options that were only slightly differentiated. There were dozens of plans. Different companies offered similar plans at different prices, which changed frequently. The program designers focused primarily on giving people quantity but not on quality.

So in the end, some 10% of seniors didn't enroll by the deadline; they would have had to pay a lot more to enroll late. Two-thirds ended up enrolled automatically by their providers, who assigned them to random plans that may not have been the best fit.

Is there a number of choices that's just right?

Long-established brain research, going back to the 1950s, has found that we are most able to keep track of five to nine choices. At that level, people feel most confident and are more likely to make a choice and be happier about it. That's about our cognitive limit. When it's 20 to 30 options or more, people are more likely to be paralyzed or frustrated.

Beyond imposing numerical limits, is there a better way that complex choices could be framed for people?

Some brokers and consultants swear by the three-by-three rule. They present choices in tiers to clients. First the client chooses from three broad categories, such as high risk, medium risk, low risk. Once the person picks among those choices, he gets another three, and finally a third set. That way you are giving them nine different sets of tradeoffs, but in a manageable way.

I can't force my 401(k) plan or my grocer to cleverly arrange my choices. What should people do when they face option overload?

Choose when to choose. Instead of trying to figure out the pros and cons of every decision, pick four or five areas of your life that really matter to you. Those are the areas where you'll really try to become an expert.

If faced with a choice that's not within one of those five areas, you should rely on experts. Part of understanding how to choose is knowing when to delegate. If it's picking a restaurant, I let my husband choose. He cares more.

What should I do in the areas where I've decided to be an expert?

Let's say that one of the five is making good investments. Before you go to a financial supermarket like Schwab or E*Trade, where you'll have thousands of individual choices, learn about the more manageable choices you'll have to make. Are you investing for the short term or the long term? What is your risk tolerance? Which categories of investments do you want to own?

So when you finally go to that supermarket with thousands of choices, you are prepared and you can quickly eliminate 90% of the irrelevant options and zero in on the ones that you want.

There's been a move to "nudge" people into better choices -- for example, through automatic enrollment in 401(k)s. Does that make sense?

Default choices are helpful, provided that the default maker is benevolent. When people don't trust the authority, it's over. It can be implemented only when the best choice is easy to discern. Everyone is largely in agreement about auto-enrollment -- everyone should save.

When it comes to deciding where the money should go, that gets controversial. The investment that works for most people might not be right for a minority. Still, my feeling is that auto-enrollment into diversified life-cycle funds -- with the chance to opt into different investments -- makes a lot of sense.

Investors often have trouble deciding how much risk they can really handle. Is there any way to make that easier?

I've been working on a study with UCLA's Shlomo Benartzi and Alessandro Previtero on risk tolerance. Most brokerages' risk questionnaires simply ask you how big a loss you can tolerate. We've found that the more vivid you make the choice, the better people are able to articulate their preferences.

For example, if you ask people if they would like to see amazing scenery, but mention there's a steep drop-off from a cliff, and then offer a free ticket to go, 90% accept. But if you instead show them pictures including that steep drop-off, only 50% accept. They better understand that it's too risky for them.

When there's a vivid scenario -- say, a picture of money leaving your wallet, not just a number -- people understand the consequences better than when they are presented with abstract notion of risk. Casinos know this, which is why they have you gamble with chips, not actual money.

So it helps to be able to see consequences in concrete ways. Could this help people in other areas?

People need to give themselves reality checks. Before credit cards, we had to budget, which made spending concrete. According to real estate agents, you can spend a third of your salary on mortgage payments. But many people, after paying their bills, have just one-quarter of their salary left for food and entertainment, and end up relying on credit cards. Before you buy, budget as if you were paying the mortgage for a while. See what it really feels like.

Finally, why do we still flock to those financial supermarkets and stores that sell 75 kinds of olive oil?

The buffet is appealing -- even if the food is worse and you put stuff on your plate you don't want. Behavioral economist Dan Ariely did an experiment with a computer game. You'd click to open doors to earn a random amount of money. You had 100 clicks. If you switched doors, you used up a click without earning any money. You did best if you realized that no door was better than another, so you shouldn't waste clicks by switching. You should keep clicking on the same door.

But in a variation, doors disappeared if you didn't click them. Those players wasted more clicks switching doors, even when they were told all the doors had the same average payout.

We like keeping our options open. The important thing is to realize there are costs to doing that.