Implications from Experimental Behavioral Finance for Improving Portfolio Selection

Robert McDonald
Northwestern University

Thomas Rietz
The University of Iowa
TIAA-CREF Institute Fellow

December 2010 |

Advisors need to understand the way investors think about decisions and the process through which decisions are made. Evidence from experimental research in behavioral finance indicates that investors often have limited computational ability and/or limited attention implying that investors will have difficulty making optimal choices when information requires complex processing, such as aggregating risks across investments or time. Evidence also shows that people pay attention to some kinds of information more than others and make decisions based on heuristics (short-cuts) instead of considering all available information. Further, investors may evaluate outcomes relative to fears, aspirations and other benchmarks such as the status quo.
The implication for investment advisors is that information should be processed and presented in a format that simplifies optimal choices, with the most important, decision-relevant information presented up front in a salient manner.
 

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