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Don't make this common mistake when picking investments for your 401(k)


When it comes to picking investments, first isn't always best. Yet 401(k) investors are more likely to invest in mutual funds "early in the alphabet," according to research from The Financial Review.

Funds beginning with A, B and C, in other words, are more likely to be selected by investors than those that begin with a letter later in the alphabet.

In fact, the first four funds listed receive 10% more money each, on average, than they would if investors' money was allocated equally among all of the options, per the report. Funds listed 11th or lower received 10% less money.

The average 401(k) plan offers 19.8 fund options, according to the report, and the more options there are, the more likely participants are to choose the top-listed funds. But the so-called "alphabeticity bias" occurs even when investors aren't given many investment choices in their 401(k) plan, the researchers behind the report found.

Two psychological short cuts humans use can help explain the phenomenon, the researchers contend: Status quo bias and "satisficing." Status quo bias, or relying on the default options given, comes into play because most 401(k) plans list their mutual fund options in alphabetical order, and investors look through them in that order.

Satisificing occurs when an individual finds an "acceptable" mutual fund offering and stops looking at the funds offered beyond that, even though there could be better options further down the list.

These tendencies can have serious consequences for retirement savings.

How to counteract alphabet bias

The researchers found that increased financial education and more resources to help workers with their investment decisions did not counteract the alphabet bias.

Instead, they suggest that plan sponsors could help participants by listing the funds in ascending order based on expense ratio or volatility. This way, more investors would likely pick the less expensive or less volatile funds, which would benefit them in the long term.

But recognizing the bias is also important, the researchers contend. That way, you will know to look beyond the top listings and consider all of your options. Rather than picking the first investment that's "good enough," reading through all of your options and comparing them is the smarter move.

Better yet, think through what's most important to you before you start looking at the fund options — say, expense ratio or total fees — and use that as a deciding factor, rather than where the fund falls on a list of names.

Fees are especially important to consider because the researchers find that a fund's expense ratio is "a more reliable predictor of future return performance than past performance," with lower expense ratios being equated with better future returns.

Alternatively, you can select a target-date fund, Jack Barry, vice president of Product Development and Strategy for John Hancock Retirement, tells CNBC Make It.

"They are determined by your estimated retirement date and provide a well-diversified portfolio of options within a single offering," says Barry. That can help you avoid the bias altogether.

Don't miss: When is it a bad idea to invest in target-date funds?

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