Asset Class Correlation Hits New High

Even as it hits alpha, correlation might itself turn into an asset class, research firm says

advisorone.com:

BY JOHN SULLIVAN, ADVISORONE

June 7, 2013 • Reprints

In what is sure to please alternative investment providers, a study released Thursday by CRISIL Global Research & Analytics, based in Mumbai, India, shows that there has been an “accentuated” correlation among traditional asset classes over the past five years when compared with any period before 2008.

CRISIL (Photo credit: Wikipedia)

The study notes the increase in correlation has also been accompanied by lower returns, thus giving cause for concern to global fund managers. Around 88% of respondents to the survey indicated that correlation was now among the top five investment risk factors, and 65% believed that correlation was causing a “material negative impact on the availability of alpha-generating opportunities.”

“Our survey shows a structural uptrend in correlation with low possibility of returning to historical levels, supported by globalization and financialization of assets,” V. Srinivasan, senior director of CRISIL GR&A, said in a statement. “This will have two implications for financial research. First, research will get further streamlined; second, we will see more investments in high-end research to capture alpha.”

1. Strong correlation, 2. Weak correlation, 3. No correlation between variables x and y. (Photo credit: Wikipedia)

According to the firm’s analysis of 33 assets and 528 pairs of correlation from 1998 to 2012, the proportion of asset classes with correlation level above 0.3 has risen from 31% to 58% between 1998-2002 and 2008-2012. This increase in correlation is particularly pronounced during the last five years, the study adds.

It notes a “material increase in correlation across all dimensions, a corresponding drop in opportunities for securing benchmark-beating returns and a reduction in the level of outperformance.”

At a more granular level, it explains, this increase is more pronounced within equities, leading to a reduction in the extent of outperformance. The equity correlation across various pairs has increased from 0.6 during 1998-2002 to a relatively steep 0.86 during 2008-2012.

English: A chart showing the correlation between MSCI World Index of equities ( yellow line ) and the US Dollar Index ( green line ). (Photo credit: Wikipedia)

This has prompted investors to pursue noncorrelated assets. However, even assets that have been historically low on correlation are now seeing a rise in correlation with their returns converging. For instance, returns from multiasset funds, which tend to invest in alternative asset classes, have converged with the MSCI World Index, an equity index.

 “We see this becoming a trend,” Suresh Krishnamurthy, director of CRISIL GR&A, added. “As newer, noncorrelated assets emerge, we see them eventually getting correlated and offering lower alpha potential over time. This calls for a healthy pipeline of new-age alternative assets to emerge.”

Even as correlation has emerged as a key risk factor, CRISIL GR&A believes it will soon develop into an investable asset class of its own, similar to the way in which volatility has transformed from a risk factor to an asset class. The signs are already visible, as seen in the CRISIL GR&A survey, which was conducted with global fund managers spread across Americas (60%), Europe (33%) and Asia (7%).

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Behavioral finance techniques really work in 401(k)s

LifeHealthPro:

BY CHRIS CAROSA

JUNE 6, 2013 • REPRINTS

... I’ve written about the problem of choice overload and the detrimental effect it has on 401(k) plans (see, “4 Proven Strategies to Reduce Choice Overload in 401(k) Plans,” FiduciaryNews.com, June 4, 2013). Behavioral finance has been a “hobby” of mine ever since I started my own firm in the mid-1990s. I like it because it’s true. It’s true when it comes to picking stocks. It’s true when it comes to buying mutual funds. And it’s especially true when designing 401(k) plan investment menu options. 

...[Here's] the real problem with choice overload – it can be the reason why a 401(k) plan fails its annual nondiscrimination test. ... As the name implies, it’s caused by there being too many choices for the participant to process. Instead of making a decision on which fund or many funds to pick, the employee makes an even easier decision – the employee chooses not to participant. ... 

Unfortunately, as we all know, nonparticipation has a dark side for the plan sponsor. It increases the likelihood of failing the nondiscrimination test. ...

See also: For this advisor, it's all academic

Along comes behavioral finance to the rescue. Studies show there are plenty of reliable ways to boost participation and leading providers and their plans are employing them with success (see, “How Plan Sponsors Can Restructure a 401(k) Investment Menu to Increase Participation,” June 5, 2013). The most obvious solution is to simply cut the number of options. 

The best solution, however, requires us to rethink the way we approach the plan itself. Almost since its very inception, the 401(k) plan has been investment-centric. ... The increasing problem, though, has been as investments become more complex, more employees are tuning out their 401(k) plans. Product salesman can regale – and sometimes even confirm – 401(k) plan sponsors to include the latest bells and whistles of alternative investments, annuities or target-date funds, but, to the average employee, that’s all nothing but a bunch of mumbo-jumbo. 

This trend has begun to reverse. We see more and more 401(k) plans adopting the idea of offering a menu of “employee categories” rather than a menu of “investment options.” Sure, in a lot of cases, they contain the same mutual funds (although the total number is well below the industry average). The difference is how the menu is worded. Gone are the catch-phrases of Modern Portfolio Theory (e.g., “asset class,” “style box” or “___-cap” anything) and in are the easy-to-understand personality descriptions like “Do-It-Yourself” and “Do-It-For-Me.” Gone is the concept of “asset allocation” and in is the idea of “aggressive,” “moderate” and “conservative.” 

Again, these new phrases may lead to the same funds, but the end is not the purpose, the journey is. We want more employees to participate – to make the journey. It doesn’t really matter what fund choice they make (well, except for money markets or other fixed income vehicles). The average asset allocation is not very different than the optimal asset allocation in terms of performance. Starting to invest earlier, more often and in greater amounts has a far greater impact on meeting your retirement goal than any particular investment a fiduciary would recommend (and, we all know, only fiduciaries should make those recommendations, but that’s another story).

I’ve seen first-hand the fruits of this new finance – this behavioral finance – reap benefits for companies using it. If you’d like to see a real-life example of a new improved 401(k) investment menu, you can find it here “Adding Categories: A Sample of a New and Improved 401(k) Investment Option Menu,” FiduciaryNews.com, June 6, 2013). Go ahead. Use it. If you like it, you can thank me by buying my book.

About the Author

Chris Carosa

Christopher Carosa, CTFA, is chief contributing editor for FiduciaryNews.com, a leading provider of essential news and information, blunt commentary and practical examples for ERISA/401(k) fiduciaries, individual trustees and professional fiduciaries. With three decades of experience in the investment industry, Carosa has helped create or found a number of financial products and firms including mutual funds, common trust funds, registered investment advisers as well as a billion-dollar trust company. He is also the author of the new book, "401(k) Fiduciary Solutions." Follow Fiduciary News on Twitter and LinkedIn.

Originally published on BenefitsPro. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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FAQ: What the new U.S. crowdfunding bill means for entrepreneurs

Image via CrunchBase

LinkedIn

Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs.

Last week, the U.S. House of Representatives passed a crowdfunding bill that will allow startups to offer and sell securities via crowdfunding sites and social networks. If passed by the Senate and signed off by the President, the bill will become a law, giving entrepreneurs new options for raising money for their companies. …

What is crowdfunding?

As the term suggests, crowdfunding is funding from a crowd of people; that is, many people provide small amounts of money to finance something. Crowdfunding has its roots in charitable causes, including the advent of microfinancing …

Can startups use crowdfunding now?

Under current laws, startups may not sell stock or other securities through crowdfunding sites or social networks… They may, however, accept donations.
This is because of applicable federal securities laws ... The laws include the following:

• A prohibition against “general solicitation” — which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor. (See “Can I Raise Money For My Startup Via Twitter?”)

• Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering too costly and onerous. (See “Ask the attorney — securities laws.”)

• A requirement that any intermediaries (including websites) must be registered with the SEC as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities. (See “Finder keepers could be losers, weepers”).

What will the new crowdfunding bill do?

Basically, if this new crowdfunding bill becomes a law, all of the foregoing prohibitions and requirements will be lifted, and a startup will be able to sell securities through crowdfunding sites like Kickstarter, or social networks like Twitter or Facebook, so long as the company (and its intermediary, if applicable) comply with the bill. According to the bill, the company will have to meet these key provisions:

• The company may only raise a maximum of $1 million, or $2 million if the company provides potential investors with audited financial statements.

• Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.

• The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.

Are there any downsides to crowdfunding for startups?

Yes, there are several key downsides that you need to be aware of before jumping into crowdfunding.
First, startups must understand that minority stockholders have certain significant rights under state law, including voting rights, the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company, and certain protections against oppression by the controlling stockholders. …
Second, having hundreds of stockholders is an administrative nightmare and will be time-consuming and costly. …
Third, startups will likely have difficulty raising funds from VCs and other sophisticated investors if they have hundreds of unsophisticated stockholders. …

What’s next?

Now we wait for the U.S. Senate, … The White House supports the House bill, so upon reconciliation, it will be signed into law. Then entrepreneurs will have a new option to consider when raising money for their startup.

About the Author, Scott Edward Walker

Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs. Scott has 15+ years of broad corporate law experience, including nearly eight years at two prominent New York City law firms. He has built a strong team of lawyers, with offices in Los Angeles, San Francisco and Washington, D.C. You can follow him on Twitter as @ScottEdWalker or check out his blog.

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QE2 and the Great Wealth Transfer: A Spurt for the Economy?: Searching for Alpha

Advisor One
November 2, 2010 | By Ben Warwick

Quantitative easing (QE) is a government strategy of printing money in order to retire debt and purchase assets that increase the size of the public balance sheet. QE1, which occurred in March 2009, effectively took the markets off the mat. QE2 will likely also light a fire under stock prices, but the effect may be short-lived.
Since the assets purchased are all debt-related, there is little doubt that interest rates will stay low or even head slightly lower. Corporations will continue to sell bonds in this environment, which will increase their cash hordes even more. As more firms start distributing this cash in the form of dividends, investors will turn their eyes away from the negligible return of CDs and Treasury notes and toward the stock market.

Image via WikipediaThe economy should respond to such stimulus, but not with the vigor of the public markets. If GDP growth doesn’t get a sufficient boost, investors will begin to focus on the falling dollar and rising government debt levels. Although I’m still expecting a rally, it may be in the form of a powerful spurt rather than a long-term trend.

Not everyone will win in the next upswing. The battered middle class, who is already cash strapped and struggling with high unemployment, won’t have the wherewithal to participate in the rally. This will serve to separate them from the upper class even more—a vexing long-term problem that we will eventually have to deal with.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached atmailto:puzzler@investmentadvisor.com.

About the Author

Ben Warwick
Contributing Editor

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Just Out of Reish - Too Safe Is Too Bad

PLANSPONSOR.com

Safe investments may not be safe…for fiduciaries
…For fiduciaries, safe means that they are protected from lawsuits either because they complied with the law or because they have a legal safe harbor. Safe—for most participants—means an investment that has very little, if any, volatility. In the investment world, volatility measures how much the value of an investment fluctuates. For example, stable value or money market accounts are intended to have a fixed principal that does not fluctuate in value.
Another important definition is time frame. When the market is highly volatile, …people tend to measure their investment results in weeks or months. However, that is inconsistent with ERISA’s approach, which would measure investment results over years, or decades, or working careers.
With that in mind, how can safe be risky for 401(k) fiduciaries, and vice versa, particularly for default investments?
Risky can be safe for 401(k) fiduciaries when selecting qualified default investment alternatives, or QDIAs. …QDIAs are the investments that can be used for participants who …fail to direct their investments, as a fiduciary safe harbor under ERISA section 404(c)(5). While there are three categories of QDIAs, this column discusses only target-date funds, or TDFs.
By legal definition—and common application—QDIAs, and therefore target-date funds that qualify as QDIAs, must have a material allocation to publicly traded stocks and, therefore, are volatile when compared with, for example, stable value investments.
The first step of our analysis is that risky or volatile investments in equities are safe for fiduciaries when used in QDIAs even though they seem less safe—or more volatile—to participants.

Image via WikipediaHowever, what about the use of safe investments, such as stable value and money markets, as default investments? In that case, what feels safe for participants is risky for fiduciaries. …Succinctly stated, the DoL viewed the riskiness of inadequate benefits at the end of a working career as being more important than the riskiness of stock and bond market volatility in the short term.

If you accept the DoL’s view on this issue, or if you want the fiduciary safe harbor protections for QDIAs, the prudent course of action is to invest default money for the long term. Based on conventional investment thinking, that means that fiduciaries should place defaulting participants in diversified portfolios consisting of, at the least, stocks, bonds, and cash.

Image via WikipediaYet, what if an employer wants to avoid possible employee criticism for investment losses? Isn’t that permissible?

It may be permissible based on the demographics of a particular work force, but only after the fiduciary has engaged in a prudent process and reached an informed and reasoned decision that a long-term investment in stable value or money market vehicles is likely to produce equivalent or superior retirement benefits. However, in that case, the fiduciaries have lost the safe harbor and, as a practical matter, the burden will be on the fiduciaries to prove their case—that is, to overcome the common belief that is expressed in the DoL language.
Even there, is it possible that there could be a lawsuit where participants have small gains, but no losses?
Yes, it is. In 1986, the DoL filed a lawsuit against a union pension trust and subsequently entered into a settlement of that lawsuit. In the press release regarding the settlement, the DoL stated, “The department has charged that the trustees caused the plan to sustain financial losses by investing virtually all of its assets in ordinary savings accounts during the period of time covered in the suit.” To help you understand the quote, ERISA considers insufficient gains to be losses. So, there you are. Risky is safe and safe is risky.

---

Fred Reish is Managing Director and Partner of the Los Angeles-based law firm of Reish & Reicher. A nationally recognized expert in employee benefits law, he has written four books and many articles on ERISA, IRS and DoL audits, and pension plan disputes. Fred has been awarded the Institutional Investor Lifetime Achievement Award and the PLANSPONSOR Lifetime Achievement Award. He is also one of the 15 individuals named by PLANSPONSOR magazine as “Legends of the Retirement Industry.”
PLANSPONSOR staff

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Regulators Release Flash Crash Probe Report

October 1, 2010 (PLANSPONSOR.com) – A trading firm’s use of a computer sell order triggered the May 6 market plunge, which sent the Dow Jones industrial average dropping nearly 1,000 points in less than a half-hour.

Image via Wikipedia

Image via Wikipedia

A report issued Friday by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) determined the so-called "flash crash" was caused when the trading firm executed a computerized selling program in an already stressed market, the Associated Press reported.  The firm's trade, worth $4.1 billion, led market players to swiftly pull their money from the stock market.

Image via CrunchBaseWhile the report does not name the trading firm, an unnamed Associated Press source identified it as Waddell & Reed, based in Shawnee Mission, Kansas.

The stock market was already stressed even before the plunge that day, according to the report, and anxiety was mounting over a debt crisis in Europe. The Dow Jones was down about 2.5% at 2:30 p.m. when the trader placed an enormous sell order on a futures index of the S&P's index. The trade on the E-Mini S&P 500 was automated by a computer algorithm that was trying to hedge its risk from price declines.
According to the Associated Press, in that one trade, 75,000 contracts were sold in a span of 20 minutes. It was the largest single trade of that investment since the start of the year; the firm's previous transaction of that size took more than five hours, the report notes. The trade triggered aggressive selling of the futures contracts and that sent the index down about 3% in four minutes. Nearly 21,000 trades were canceled in the coming weeks because the exchanges deemed them erroneous.
Responding to the episode, the SEC and the major U.S. exchanges, agreed on a six-month pilot program that briefly halts trading of some stocks that mark big price swings (see SEC Approves, Extends New Circuit Breakers).  The new circuit breakers are in effect until December 10. Under the rules, trading of any Standard & Poor's 500 stock that rises or falls 10% or more within a five-minute span is halted for five additional minutes, the AP said.
The 104-page SEC-CFTC report is at http://www.sec.gov/news/studies/2010/marketevents-report.pdf.
Fred Schneyer
editors@plansponsor.com

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A Better Choosing Experience

When consumers are overwhelmed with options, marketers should give them what they really want: ways of shopping that lower the cognitive demands of choosing.

strategy+business magazine

Image via Wikipediaby Sheena Iyengar and Kanika Agrawal

Illustrations by Andreas Samuelsson

Image via WikipediaWhen Baskin-Robbins, now the largest ice cream chain in the world, opened in 1953, its line of 31 flavors — one for every day of the month — was a novelty. … Cofounder Irvine Robbins said, “We sell fun, not just ice cream,” and part of the fun for customers was the experience of seeing and tasting so many new flavors. The company continues to emphasize variety; …

Today it seems obvious to offer consumers more choice — but the experience is no longer a novelty, or nearly as much fun. Whereas in 1949 the average grocery store stocked 3,700 products, the average supermarket today has 45,000 products, and the typical Walmart has 100,000 products. Online are even more options, … Starbucks, … recently launched the However-You-Want-It Frappuccino, with “thousands of ways to customize your blended beverage.” Cold Stone Creamery claims that its menu of mix-ins provides more than 11.5 million ways to “customize your ice cream treat.” Long gone are the days when an array of 31 flavors knocked our socks off.
Consumers have grown accustomed to having a lot of choice, and many people still express a strong desire for having more options. But that doesn’t make it a good idea. There are neurological limits on humans’ ability to process information, and the task of having to choose is often experienced as suffering, not pleasure.
That is why, rather than helping consumers better satisfy their preferences, the explosion of choice has made it more difficult overall for people to identify what they want and how to get it. … [You] can outthink and outperform your competitors by turning the process of choosing into an experience that is more positive and less mind-numbing for your customers. …
The goal of a new approach to choice should not be to manipulate consumers into making choices that aren’t right for them, but rather to collaborate in a way that benefits both of you. … To accomplish this, here are four actions you can take:

1. Cut the number of options.
2. Create confidence with expert or personalized recommendations.
3. Categorize your offerings so that consumers better understand their options.
4. Condition consumers by gradually introducing them to more-complex choices.

Offered together, these actions can distinguish your company. … [You’ll] be one of those rare companies whose offerings rise to the top by raising customer spirits.

The Multiple-choice Problem

Image by s.alt via Flickr…[In] the mid-1990s, … Sheena Iyengar conducted a study of shopper selection at … Draeger’s, a specialty grocery store renowned for its huge selection of produce, packaged foods, and wine. Iyengar realized that although she greatly enjoyed visiting the store, she often walked out empty-handed, unable to settle on just one bottle of mustard or olive oil …

… Iyengar and her collaborator, Mark Lepper, set up a jam-tasting booth near the entrance of the store. Every few hours, the booth switched between offering an assortment of 24 jams and an assortment of six. The researchers wanted to know which assortment would attract more people and which one would lead to higher sales. They observed the shoppers as they moved from the booth to the jam aisle, which boasted 348 varieties.
As might be expected, 60 percent of the incoming shoppers stopped when 24 jams were displayed, but only 40 percent stopped when six jams were displayed. Clearly, people found the larger assortment more attractive. However, when these same shoppers went to the jam aisle to pick up a jar, the shoppers who had seen only six jams had a much easier time deciding what to purchase.

By observing the shoppers and eavesdropping on their conversations, the researchers discovered that the small assortment helped people narrow down their choices, whereas the large assortment left them confused and unsure of their own preferences. Of those who stopped by the large assortment, only 3 percent ended up buying a jar of jam — far fewer than the 30 percent who bought jam after stopping by the small assortment. … Iyengar and Lepper calculated that people were more than six times as likely to buy jam if they saw the small display.
… People like the idea of choice. … In short, they believe that having more choice gives them more power and satisfaction.
But they overestimate their own capacity for managing these choices. Psychological studies have consistently shown that it’s very difficult to compare and contrast the attributes of more than about seven different things. When faced with the cognitive demands of choosing, people often become overwhelmed and frustrated. As a result, they may forgo the choice altogether, reach for the most familiar option, or make a decision that ultimately leaves them far less satisfied than they had expected to be.
We see this frustrated response to “choice overload” even when the decision has serious consequences. …[At] the request of Steve Utkus, the director of the Center for Retirement Research at the Vanguard Group, Iyengar and her collaborators, Wei Jiang and Gur Huberman, tried to determine why so few of the 900,000 employees covered by Vanguard were participating in their … 401(k) plans. Analysis of the data revealed that participation fell significantly as the average number of funds in a plan rose. By controlling for individual-level variables such as age and income, as well as plan-level variables such as the size of the company and the extent of employer matching contributions, Iyengar and her collaborators showed that the decline in average participation rates was due to an increase in choice. When plans offered only two funds, 75 percent of the relevant employees participated; when plans offered 59 funds, the percentage of participants fell to 61 percent. …
Moreover, Iyengar and Emir Kamenica discovered that the employees who participated made worse investment decisions, on average, when they chose from plans with more options. For every 10 additional funds offered in a plan, employees allocated 3.28 percent less of their contributions to equity funds (as opposed to bond or money market funds), and they were also more likely to avoid allocating any of their contributions to equities at all. … Even employees in their 20s, who should have been allocating 80 to 90 percent of their contributions to equities (based on the accepted wisdom of financial advisors), became more likely to entirely avoid equities as the number of options rose, undermining their long-term financial well-being.
The deleterious effects of too much choice have been observed in other situations as varied as buying chocolate, applying for jobs, and making healthcare decisions. … People keep expressing a desire for more choices, and businesses keep expanding product and service options in order to fulfill this desire — but it often does more harm than good.
Don’t marketers have to give consumers what they want? Yes and no. … When consumers say they want more choice, more often than not, they actually want a better choosing experience. They want to feel confident of their preferences and competent during the choosing process; they want to trust and enjoy their choices, not question them. … The following four means will help you meet that challenge.

Image via Wikipedia1. Cut their alternatives. … Most companies avoid reducing the number of products they offer because they’re afraid of losing shelf space to their competitors. But careful trimming can lower costs, increase sales, and improve the choosing experience for consumers. In the mid-1990s, when Procter & Gamble Company winnowed its 26 varieties of Head & Shoulders anti-dandruff shampoo down to 15, … sales jumped by 10 percent. In a similar case, the Golden Cat Corporation got rid of its 10 worst-selling offerings in the small-bag cat litter category. This led to a 12 percent increase in sales and slashed distribution costs by half; the end result was an 87 percent profit hike. Another example comes from a 2001 study that tracked an online grocer that had made substantial cuts in the number of products it offered, … Not only did sales rise an average of 11 percent across 42 categories, but 75 percent of its customer households increased their overall expenditures.

… Potential consumers should be able to zero in on a product’s defining characteristics and explain why it is (or is not) appealing to them. If people respond vaguely or inattentively, that’s a signal that the choices you offer are not distinct enough and should be consolidated.
2. Create confidence through recommendations. Reducing options works well when the variations between products are relatively small. But for highly differentiated goods — books, prerecorded music and video, clothes, and many housewares — you can’t get away with offering a small selection. … Instead, you have to offer a wide variety while helping consumers navigate the complexity so they still have a positive choosing experience. …
Through study and practice, experts in any field learn to simplify, categorize, and prioritize information, and to recognize patterns. This allows them to create order out of seeming chaos. …
In high-choice conditions, the ideal consumer is the most expert consumer. That doesn’t mean someone with in-depth expertise in any one type of product. … However, novice consumers can become expert general consumers by learning to rank and structure their choice sets the way that experts do.
Marketers can thus help novices make more-educated guesses and create confidence in their choices by giving them easy access to expert reviews and recommendations. … Even non-expert advice can prove useful when there is consensus among a large number of reviewers or when the consumer trusts the source. This is one reason for the popularity of shopping websites with user reviews …
Another way to give consumers access to recommendations, … is to set up automated systems that generate suggestions based on consumers’ expressed preferences. These systems, …are software programs that guide people by analyzing their prior purchases or their answers to survey questions. If consumers are willing to invest a little time teaching a well-designed system about their preferences, then the system can serve as a personalized expert for them. People don’t usually trust programs as much as they trust other people, but trust in well-performing electronic agents tends to develop over time.

Image via CrunchBaseFor example, the Internet radio service Pandora has acquired 50 million users who tune in for an average of 12 hours a month, even though (or perhaps because) they cannot directly choose what they’ll hear. Pandora’s “mission” is to “play only music you’ll love,” and it accomplishes this by combining human expertise with an automated system. First, trained analysts determine the musical attributes of every song in the database. …Then, when users tell the system what music they like, it searches for other music with similar attributes. As they listen to their personalized music streams, users can let the system know how well it matched their preferences. Eventually, the system comes to “know” the users well enough that they no longer have to provide feedback. They can just sit back and enjoy.

3. Categorize their options. You can also help novices by teaching them to emulate expert judgment. For an expert, there is no completely unique product or service; rather, each offering is a distinctive combination of attributes that the expert has seen before. Thus, where the novice sees 100 different items, the expert sees maybe seven or eight relevant qualities interacting in novel ways, with one or two important features that immediately stand out. The trick is to get the novice to see things as the expert sees them.
The easiest way to do this is to categorize. For example, Best Cellars, Wine Enthusiast’s Retailer of the Year in 2009, makes the choosing process a breeze for its customers by consulting with oenophiles in advance. It draws on their advice to limit its variety to 100 high-quality, reasonably priced wines. Since 100 wines could still be an overwhelming number for novices, Best Cellars divides the wines into eight simple categories, such as “fizzy,” “juicy,” and “sweet.” The novice has to deal with only eight units of information now, which can be managed fairly easily. Once the novice has chosen a category, he or she can choose a wine within that category by reading the detailed labels that accompany all the bottles.
… By pre-sorting the wines into categories, the retailer helps novices look at the world through expert lenses. Best Cellars cofounder Joshua Wesson says, “We all want simplicity when it comes to these types of decisions…. We try to make wine shopping as much fun as wine drinking.” Note that this is the flip side of what Baskin-Robbins did in its heyday. Both retailers have thrived by creating a better choosing experience. Back then, this meant giving customers more choice; now, it means giving them less.

Image via WikipediaTo simplify the choice process, limit your categories to no more than 20, with 10 or fewer options in each. When you hold to these limits, consumers are likely to feel empowered by the number of choices, and are unlikely to miss any offerings that weren’t included. Iyengar and her collaborators, Cassie Mogilner and Tamar Rudnick, discovered this when studying the magazine aisles in several Wegmans supermarkets. The number of magazines available at various branches ranged from 331 to 664, but this number had no effect on buyer satisfaction. What mattered was the number of categories, … that each display provided. Arranging the magazines under a wider range of subheadings created the perception that the store offered more choice, even when the number of magazine titles was comparatively small. Customers in these stores also reported greater enjoyment of their overall shopping experience.

…[The] categories established by a marketer or retailer provide a framework for making sense of a large assortment, thus keeping consumers from being discouraged by the daunting task of choosing. …[These] categories … also provide a general overview of the field, which catalyzes consumers’ understanding of it and the development of their preferences within it.
4. Condition them for complexity. For certain kinds of decisions, you can set up consumers for success by encouraging them to learn from, and build upon, their own previous choices. This is especially valuable if your product is customizable.
For example, Iyengar and her collaborators, Jonathan Levav, Mark Heitmann, and Andreas Herrmann, conducted a study with a major German car manufacturer that allows customers to design their new cars from a long list of options, choosing everything from the engine to the rearview mirror. They presented the first eight design choices in different sequences to different groups of car buyers. One group had to choose  [design elements from categories that went from high choice to low choice]. A second group of buyers encountered the same choices in reverse order, starting with the design elements that offered the fewest options and ending with the ones that offered the most. Although both groups eventually saw 144 total options across eight categories, the buyers who moved from high choice to low choice had a much harder time. They began by carefully considering every option, but they soon grew tired and settled for the default. In the end, they wound up less satisfied with their cars than the buyers who had progressed from low choice to high choice.
This research shows that people can handle a large number of options, if they start off in the shallows and then slowly move toward the deep, all the while building skill and nerve. Beginning with fewer options not only warms up consumers, it helps them better figure out their own preferences, which in turn enhances their choosing experience. Over time, practicing this choosing technique will condition consumers to cope with increasing complexity.
An Open Invitation
Each of these forms of customer engagement can be technologically enabled, …. But the heart of this method lies in better design of the shopping experience, fueled by better awareness of human capabilities. When you take this approach, … your goal is to invite consumers to enter into a collaborative, mutually beneficial relationship with you.
From the outset, your design shows them that you understand how they think and respect their desire for both control and simplicity. The message is clear: In the short run, you are helping them navigate a bewildering and even debilitating world of options. In the long run, you are inviting them to choose you.

Author ProfileS:

• Sheena Iyengar is the S.T. Lee Professor of Business at Columbia University and a recipient of the Presidential Early Career Award. She is the author of The Art of Choosing (Twelve, 2010), from which this article is adapted.
• Kanika Agrawal is a research assistant at the Columbia Business School and a graduate of Columbia’s MFA program in writing.

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