I believe in trusting my instincts when making decisions. However, when it comes to investment decisions, I have learned firsthand that my gut will often lead me down the wrong path. Many studies and surveys continue to support I am not the only one in that camp. Recently, Scott Bosworth, VP at Dimensional Fund Advisors Ltd., spoke at the National Association of Personal Financial Advisors conference on the topic of behavioral-finance research to explain some of the mistakes investors make when they ignore asset allocation, otherwise stated as their personal investment recipe.
A whole range of biases color investor thinking, Mr. Bosworth said. Investors become overconfident, think they have more control than they really do, and give themselves way too much credit when things go well and too little of the blame when things go wrong.
“Every study says we are overconfident in a lot of things,” said Mr. Bosworth. “It drives innovation and progress.” But when it comes to investing, relying on investment hunches and beliefs can be deadly, he said. “We find reasons, even if mounting evidence says we are wrong.”
Mr. Bosworth said there is a link between behavioral finance theories and the efficient-markets theory that underlies passive investment and asset allocation models. Financial advisers need to have an understanding of both disciplines in order to handle their customers’ concerns while sticking to the straight and narrow path of passive investing in an appropriate mix of index funds.
“Behavioral finance, how you deal with the client, is more important,” Mr. Bosworth said. “If you can solve that part, help them understand risk and return, and keep them diversified, you have won the biggest part of it.”