People often tell me that investing is so complicated that they don’t even know where to start. It turns out that the seemingly complicated nature of money is the reason that many physicians don’t want to learn this stuff. Those who are fledglings in the world of personal finance will often say, “I know that I need to save and invest money, but what do I invest in?” Alternatively, people who know a little more may ask about the “right” asset allocation for their investing plan. The reason that these questions are so common is that people are paralyzed by choice. With everything out there, how do they choose between the options?
In this Behavioral Finance Series post (click here to see the rest of the posts in the BFS series), we will discuss some of the science behind our choices, and how keeping it simple wins for a lot of reasons.
To learn more about how to keep it simple with the 20% of personal finance doctors need to know to get 80% of the results, I recommend purchasing The Physician Philosopher’s Guide to Personal Finance here from Amazon. It is a quick read with a five-star review.
The Jam Experiment
In the year 2000, two psychologists (Lepper and Iyengar) studied choice. The question that they asked was whether people were more likely to purchase a product if they were provided more or less choice.
To do this, they compared two different sales tactics in a grocery store. The product that they were trying to sell was jam. You know, the stuff I eat every day with my peanut butter and jelly sandwich?
The jam sales involved two set-ups. The first was a basic set up with only 6 different varieties of jam. The second set up involved 24 varieties of jam. And these set ups were rotated hourly on two different Saturdays in an upscale grocery store.
The end result was that the 24 jam display attracted more people (60% of shoppers stopped to take a look compared to 40% for the 6-jam set up). However, even though more people stopped by, they were much less likely to buy!
Only 3% of those who stopped by the 24-jam display purchased a jar of jam compared to a 30% sales rate at the display with less choice.
What we should realize from this study is that human beings like things that shimmer and shine. We like the allure of variety. However, we also like it when our choices are limited. When too many choices are offered, we are often paralyzed by indecision. Less choice often means an easier decision.
Less is More in Investing, Too
In the same way that people are paralyzed by too many choices in the grocery store, investors often have a tendency to be paralyzed by indecision when it comes to investing.
There are more than 2,500 individual stocks to choose from on the New York Stock Exchange. If we have a hard time choosing between 24 varieties of jam, imagine how paralyzing this choice must be for those who want to start investing money in the market.
That said, studies have shown that – despite the tools that exist to attempt to predict future returns – even people that get paid professionally to pick stocks are not very successful at it. And, there is good reason.
History will teach us that it is very hard to figure out which companies will fly and which will fail. If we take a look through history at the 500 biggest companies in the U.S. from 25 or 50 years ago, we will see that not many remain successful over time.
How in the world do we pick which ones are likely to find success?
This is one of the many reasons that individual stock picking is not recommended. Fortunately, there are much better (and simpler) ways to invest our money. Instead of being paralyzed by the 2,800 choices offered in the market, we can purchase the whole market through passive-index funds.
Index Funds Still Have Choices
However, we still haven’t made our goal of creating less choice, because there’s more than one passive index fund that we can purchase. In fact, there are hundreds of various index funds, if not thousands. So, we are left with the same paralysis by analysis.
Yet, I want to make it simple, because that is how we can get you started!
So, how do we make this decision simpler? Well, you could look at the 150 portfolios that White Coat Investor says are reasonable to invest in, and simply pick one that seems to fit your needs.
But, if we have a hard time picking from 24 jams, 150 choices is probably still too overwhelming.
So, to limit the number of “jams” you have available to you investing, here are some really reasonable asset allocations that you might consider. It can be as simple as a two, three, or four fund portfolio.
You could pick something that buys as much of the market as possible with two simple funds:
- The Total Stock Market fund (follows an index of the entire U.S. stock market)
- The Total Bond Index Fund (does the same for all of the bonds in the U.S.)
As you finish residency, you might start with a stock to bond ratio of 80/20 (80% stocks/20% bonds) and increase that number by 10% with each decade until you are 60/40.
Three Fund Portfolio
Then, there is the famous Boglehead’s three fund portfolio, which adds one more asset class to that seen in the two-fund portfolio above: the total international stock market index.
The reason for this addition is that the two-fund option mentioned above does not include any international stocks. What if the American stock market takes a plunge? There is a lot to be gained by a little diversification.
This is a very popular investing plan. And it is also very reasonable.
Four Fund Portfolio
What if your employer doesn’t offer total stock market funds? Well, you might consider investing in a various asset class index funds. For example, you could place 25% into each of the following funds:
- Large-Cap Index Fund (e.g. S&P 500 fund)
- Small-Cap Index Fund
- International Stock Index Fund
- Total Bond Index Fund
This is a 75% stock to 25% bonds ratio, which is a reasonable place to start.
The point here is that it doesn’t have to be complicated. Sticking to the plan will matter infinitely more than what portfolio you choose.
So that I avoid causing the problem I am trying to teach you to avoid, I am going to stop here. The two most important parts of investing are starting investing early and staying the course.
However, in order for you to do that, you have to get started first! Don’t let the variety of choices slow you down. Pick a portfolio and stick with it. As you get more advanced, you might consider adding more asset classes (e.g. real estate), but the most important part is to get started today!
If you need some help making a financial plan that works for you, I recommend checking out the Fire Your Financial Advisor Course that will walk you through the process. If you, instead, would prefer some professional help to get you started, then consider checking out the list of recommended financial advisors on this site.
What do you think? Did you have a hard time getting started because of all of the choices that were out there? What resource did you ultimately use to get you started? Leave a comment below.