“A” look at Alphabeticity Bias in 401(k) Investing

"A" look at Alphabeticity Bias in 401(k) Investing

Thomas W. Doellman John Cook School of Business

Saint Louis University 3674 Lindell Blvd. St. Louis, MO 63108 tdoellma@slu.edu

Jennifer Itzkowitz Stillman School of Business

Seton Hall University 400 South Orange Ave South Orange, NJ 07079 jennifer.itzkowitz@shu.edu

Jesse Itzkowitz Sy Syms School of Business

Yeshiva University 215 Lexington Ave New York, NY 10016 jitzkow1@yu.edu

Sabuhi H. Sardarli College of Business Administration

Kansas State University 2097 BB, 1301 Lovers Lane

Manhattan, KS 66506 ssardarli@ksu.edu

"A" look at Alphabeticity Bias in 401(k) Investing

Abstract As defined contributions savings plans have grown in prevalence, so have individuals' responsibility over their financial futures. Therefore, structural factors which cause irrational investment are of great concern. Using a large proprietary database of 401(k) plans we show how a fund's name biases investor choice. Specifically, we show that alphabeticity ? the order that fund names appear when listed in alphabetical order ? affects fund investment. While we further show a larger impact as the number of funds in a plan increases, we show this bias is strong even when relatively few funds are available in the plan menu. Interestingly, we also find that finance professionals are just as likely to fall prey to the alphabeticity bias as both blue collar workers and non-finance professionals.

JEL Classification: G10, G11, G20, G21, G23

I. Introduction Investments in 401(k) and other defined contribution (DC) plans compose a significant portion of Americans' retirement savings. According to the Investment Company Institute's (2016) annual report, as of June 2015, over $6.7 trillion in assets were held in defined contribution (DC) plans, accounting for 28% of all U.S. workers' retirement assets. As DC plans have grown in prevalence, so have individuals' responsibility over their financial futures. Thus, it is critical to understand the various forces that shape individuals' investment decisions in these plans. One particular area of concern is where individuals' decisions cause them to pursue suboptimal investment strategies. Prior work has shown that a number of factors can preclude 401(k) plan participants from investing rationally: bias, behavioral inertia, framing, and a lack of financial literacy.1 This paper considers a new behavioral bias ? alphabeticity ? in the context of 401(k) investing and studies its potential effects on participants' investment decisions. Alphabeticity is the phenomena in which early alphabet options are chosen more frequently than others. Two psychological processes contribute to the early alphabet effect: status quo bias and satisficing. Investment options within 401(k) and other DC plans are most often listed in alphabetical order. While many investors can now access their plan online and may have the ability to re-order their list of fund choices, individuals generally rely on the default (status quo) lists given to them (Kahneman et al. 1991; Samuelson and Zechkauser 1988). As a result, because funds were initially listed in alphabetical order, they remain in alphabetical order when participants make fund allocation decisions within the plan. Second, reliance on the status quo interacts with individuals' tendency to satisfice, or to truncate their information search prior to evaluation of all available options. When choosing between multiple alternatives, each possessing different attributes, individuals typically satisfice, where their search ceases after the first "acceptable" option is found, even if continued searching could yield a better result (Caplin et al. 2011; Payne 1976; Simon 1956). So, when a participant searches through her plan's menu of

1 A few examples of this literature include Agnew et al. (2003), Benartzi and Thaler (2001, 2007), Duflo and Saez (2002), Finke et al. (2017), Huberman and Jiang (2006), Lusardi and Mitchell (2007), and Madrian and Shea (2001).

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investment options, she may be more likely to choose the funds appearing towards the beginning of the list. Since 401(k) fund choices with early alphabet names appear at the beginning of the list they will be chosen more often than later alphabet funds.

While alphabeticity has been shown to affect other types of decision making, including stock choice,2 differences between stock market investing and investing in 401(k) plans may mitigate the likelihood of alphabeticity affecting investment choice. Stock market investors have thousands of investment options to choose from, each of which has an overwhelming amount of information available for investors to sift through making it impossible to consider every option. In contrast, 401(k) investors typically choose from a relatively small number of funds making it possible for investors to consider every option.3 Because alphabetical bias relies on investors' truncated search, alphabeticity may not affect fund choice in 401(k) plans like it does stock choice.

We find that alphabeticity indeed affects investment allocation decisions in DC plans. Consider a 401(k) plan that offers the following 13 funds options (which are listed in alphabetical order in the plan offering): Brandywine, Columbia Acorn, Dodge & Cox Stock, Fidelity Contrafund, Fidelity Freedom Income, Fidelity Puritan, Forward Small To Mid Cap, Harbor Capital Appreciation, Pimco All Asset All Authority, Pimco Commodity Real Return Strategy, Royce Pennsylvania Mutual, T. Rowe Price Blue Chip Growth, Vanguard 500 Index. We find that if the Royce fund changed its name to American Royce

2 Research in other disciplines has shown that alphabeticity influences many different decision processes. Politicians with early alphabet names are more likely to be elected than their competitors (Edwards 2015). Scholars with last names that begin early in the alphabet are invited to review papers more often than those with last names that start with letters later in the alphabet (Richardson 2010). And, because they are solicited more often, alumni with early alphabet names donate more than those with later alphabet names (Meer and Rosen 2011). Stocks beginning with early alphabet letters have higher turnover, liquidity, and valuation than later alphabet stocks (Itzkowitz et al. 2015; Itzkowitz and Itzkowitz 2016; Jacobs and Hillert 2016). 3 Plans in our sample contain an average of 20 funds. The plan with the most funds has only 75 options.

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Pennsylvania Mutual (a 10 position increase, moving it to the top position when listed in alphabetical order), investment in the fund would increase by roughly 20 percent, all else equal. As the average fund in our sample has a 9.9% allocation to it, the American Royce Fund would see its allocation increase to 11.9%. Given the typical plan has roughly $32.5 million in assets, this move represents an additional allocation of $650,000 to the Royce fund.

Having established a significant relation between alphabeticity and participants' investment allocation decisions, we then analyze how two specific plan characteristics might influence the effect of alphabeticity on these allocation decisions. First, we investigate how plan size (i.e., the number of fund options within a plan) affects alphabetical bias. Because individuals who are exposed to large numbers of options are more likely to rely on heuristics when making choices (?lk?men, Chakravarti, and Morowitz 2010), there could be greater evidence of alphabeticity in plans offering more fund choices. The results support this hypothesis. Plans offering more fund choices show significantly greater participant investment in early alphabet fund options than plans that offer fewer fund options. Interestingly, while plans with larger fund offerings in our sample do exhibit greater bias as one might expect, we find that the bias exists even in plans with fewer than 10 fund choices.

Next, we consider the impact of investor expertise on alphabeticity in 401(k) investing. Specifically, we use business profession as a proxy for expertise. On one hand, expertise may protect professionals from making biased investment decisions. That is, according to this expertise hypothesis, compared to blue collar workers, professionals have training and experience at performing complex analytical tasks ? skills that may allow them to better manage their attention and effort (Alba and Hutchinson 1987). Alternatively, expertise may ironically result in more biased investing. Because of their extensive use of analytical skills on the job, professional workers could experience cognitive depletion, the loss of the ability to focus and make complex decisions, after a day of work. As a result, according to the ego-depletion hypothesis, professional workers would exhibit greater alphabetical bias than their blue collar counterparts. Finally, similar to the widespread failure of financial education to

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