What does behavioral finance tell us about investing and indexing?
Ed McRedmond, Invesco PowerShares (McRedmond): I discussed this topic with my colleagues here at Invesco PowerShares, along with John West at Research Affiliates, and it’s our collective opinion that behavioral finance may explain the collective lack of rationality and consistency with which we reach our investment decisions. Much of modern finance theory rests upon the assumption that investors make rational, well-informed decisions based solely upon a consistent view of risk and reward. However, inconsistencies and irrational behavior are embedded into human economic behavior—consider buying a lottery ticket and an insurance policy with the same paycheck! Behavioral finance experiments and research have confirmed many cognitive errors—behaviors that contradict the standard assumptions of rationality but are part of human nature. These lead to errors in the pricing of assets. JoI: What are the biggest mistakes investors make from a behavioral standpoint? McRedmond: Some common cogniti
