Too much choice and no decisions - A story of hedge fund manager selection

The paradox of choice is a recurring problem in marketing and decision-making that has not been fully explored within institutional investment decision-making. The paradox of choice states that if there are more alternatives to choose from, it will less likely that a consumer will make any choice.

Look at all of the mutual funds and ETF choices available to investors. Look at all of the hedge fund choices. All have been developed to offer more alternatives to investors, so they have better return opportunities, yet the science supports the view that more choices leads to paralysis and fewer choices. In a competitive market, the suppliers of choices will not volunteer to close and reduce the choices, so it is up to the  investor to solve the choice problem. 

Investors always have the fear of regret. Too many choices and an investor believes that he will likely make the wrong decision; therefore, avoid playing the game. There also is the Hick's Law of reaction which states that more choices will reduce the reaction time for any decision. Too many choices can be overwhelming.

Investors will institutionalize limits on choice to make life easier; however, they need to be aware of what they are doing when they impose restrictions on choice. Investors form decision trees of restrictions to limit their choices, bind behavior, and reduce regret.

For example, if you say that there is a firm rule that a hedge fund manager has to have a three-year track record, you can eliminate all new managers. Have a strict operational due diligence, and more managers are eliminated. Have a minimum AUM requirement and even more managers will be eliminated. You are bound by institutional choices without regret. The field has been narrowed without the drama of having to choose. If you use a consultant, you can have them cut the list to a manageable number so a decision can be made. Investors bind themselves to all for better decision freedom.   

Is this behavior rationale? Yes, by a standard that a formal process is used to focus on a limited set of managers. The binding behavior allows for more efficiency. Is this optimal? No. Good managers will be excluded. However, if the funnel is too restricted the choice tree can be widened. It is a practical heuristic to solve the problem of too many choices, yet it generates financial inefficiency.