Why Do Smart People Make Dumb Investment Mistakes?
by Chris Brown, Ph.D., MBA, CFP® and Ron A. Rhoades, JD, CFP®
This is Part 5 of Scholar Financial’s “Evidence-Based Investing” series. To view the entire series, click here. To receive bi-weekly updates on the rest of this series, please join our email newsletter by clicking here.
Dr. William Torres spent 30 years as a professor of economics. He taught courses on rational decision-making. He published papers on market behavior. He took pride in his analytical mind.
When the market dropped sharply in early 2020, William knew exactly what the research said to do: stay the course, maintain his allocation, perhaps even rebalance into the decline. But in the moment, watching his retirement savings plummet, something else took over. He moved everything to cash.
Within months, the market had recovered – and then surged to new highs. William, still sitting in cash, paralyzed by uncertainty about when to get back in, had missed one of the fastest recoveries in market history. An economist who knew better had made a classic behavioral mistake.
If it could happen to him, it can happen to anyone. The question is: why?
Our Brains Weren’t Built for Investing
Evidence-Based Investing incorporates insights from behavioral finance – the study of how emotions and cognitive biases affect financial decisions. The findings are humbling: we humans are not always rational when it comes to money.
Our brains evolved to survive on the savanna, not to manage investment portfolios. The same instincts that helped our ancestors escape predators – fight or flight responses, pattern recognition, herd behavior – can wreak havoc on our financial decisions.
The Rogues’ Gallery of Investment Biases
Research has identified numerous biases that lead investors astray.i We may panic and sell during market downturns – precisely when we should potentially be buying. We chase performance by investing in whatever has recently done well – often buying high. We exhibit overconfidence, believing we can pick winning stocks or time the market despite overwhelming evidence that even professionals rarely succeed.
Pioneering research by Daniel Kahneman and Amos Tversky, which earned Kahneman a Nobel Prize, demonstrated that people feel the pain of losses roughly twice as intensely as they feel the pleasure of equivalent gains.(1) This “loss aversion” helps explain why investors panic and sell during market downturns—the pain becomes unbearable, even when rational analysis says to hold firm.
We anchor on irrelevant information, like the price we originally paid for an investment.(2) We suffer from recency bias, giving too much weight to recent events.(3) We see patterns where none exist and make predictions based on insufficient data.(4)
Studies by researchers like Brad Barber and Terrance Odean have documented the real-world costs of these biases. Their research shows that individual investors who trade frequently significantly underperform those who trade less—largely because they’re acting on emotional impulses rather than sound strategy.(5)
The Investment Policy Statement: A Written Commitment
Evidence-Based Investing offers a powerful antidote to behavioral biases: the Investment Policy Statement, or IPS. This written document outlines your investment goals, risk tolerance, and strategy. It serves as a roadmap for making investment decisions.
The genius of an IPS is that you create it when you are calm, rational, and thinking clearly—not when markets are crashing and fear is gripping your gut. By committing in advance to a specific strategy, you create guardrails that can prevent emotional decision-making.
An effective IPS specifies your target asset allocation, your rebalancing approach, and what circumstances – if any – would warrant changes to your strategy.(7) When markets tumble and your instincts scream to sell, you can consult your IPS and remind yourself: “This is what I said I would do. I made this plan when I was thinking clearly.”
Rebalancing: Discipline in Action
Portfolio rebalancing is another example of Evidence-Based discipline overcoming human nature. Over time, as different investments perform differently, your portfolio drifts away from your target allocation. After a stock market surge, you might find yourself holding more equities than intended – taking on more risk than you planned.
Rebalancing means periodically selling some of what has gone up and buying some of what has gone down to restore your target allocation. This feels deeply counterintuitive. Every instinct tells you to keep your winners and dump your losers. But systematic rebalancing does exactly the opposite – and research suggests it can actually enhance returns over time through a process called “volatility harvesting.”(8)
When you rebalance, you’re essentially selling high and buying low – the holy grail of investing that our emotions constantly push us to reverse. A disciplined rebalancing approach takes the decision out of your hands and replaces impulse with process.
Dr. Torres Finds His Footing
After his costly mistake, Dr. Torres did something many would not: he studied his own failure. His new financial advisors provided him with the behavioral finance research he had long known intellectually but never applied to himself. He understood that knowing about biases doesn’t make you immune to them.
“I had spent my career teaching rationality,” he reflected. “But in a crisis, I was just as irrational as anyone else. The difference now is that I have systems in place, and trusted and knowledgeable finance professors and advisers, to protect me from myself.”
At 63, with the aid of his new fee-only, fiduciary advisers, William created a comprehensive Investment Policy Statement. It established automatic rebalancing. His new fiduciary investment advisers would serve as behavioral coaches during turbulent times – to remind him of his plan when emotions threatened to derail it.
The smartest investors are not those who think they can outsmart their emotions. They are the ones who acknowledge their limitations and build systems to overcome them. Evidence-Based Investing recognizes that we are human – and then creates frameworks to help us invest wisely despite our very human brains.
Why do smart people make dumb investment mistakes? Because they’re human. But with the right systems, and aided by trusted, knowledgeable advisers, even our flawed human minds can follow an evidence-based path to long-term success.
About the Authors
Ron A. Rhoades, JD, CFP®
Ron Rhoades is an Associate Professor of Finance at the Gordon Ford College of Business, Western Kentucky University. He also serves as a financial advisor at Scholar Financial, a practice within XY Investment Solutions LLC. With a background as both an attorney and a CERTIFIED FINANCIAL PLANNER™ professional, Ron is a nationally recognized authority on the fiduciary duties of financial advisors.
Chris Brown, Ph.D., CFP®
Chris Brown is a faculty member in the Department of Finance at the Gordon Ford College of Business, Western Kentucky University, and a financial advisor at Scholar Financial, a practice within XY Investment Solutions, LLC. He holds the CERTIFIED FINANCIAL PLANNER™ designation and a Ph.D. in Personal Financial Planning. His research and teaching focus is on behavioral finance, retirement planning, and evidence-based investment strategies.
Endnotes
1. See, e.g., Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55(2), 773-806. Also see, e.g., Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-292.
2. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263–291. https://doi.org/10.2307/1914185.
3. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131. https://doi.org/10.1126/science.185.4157.1124.
4. De Bondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact? The Journal of Finance, 40(3), 793–805. https://doi.org/10.1111/j.1540-6261.1985.tb05004.x.
5. Kahneman, D., & Tversky, A. (1972). Subjective probability: A judgment of representativeness. Cognitive Psychology, 3(3), 430–454. https://doi.org/10.1016/0010-0285(72)90016-3.
6. See, e.g., Barber, B. M., & Odean, T. (1999). The courage of misguided convictions: The trading behavior of individual investors. Financial Analysts Journal, 55(6), 41–55. https://doi.org/10.2469/faj.v55.n6.2313; Odean, T. (1999). Do investors trade too much? The American Economic Review, 89(5), 1279–1298. https://doi.org/10.1257/aer.89.5.1279; Statman, M., Thorley, S., & Vorkink, K. (2006). Investor overconfidence and trading volume. Review of Financial Studies, 19(4), 1531–1565. https://doi.org/10.1093/rfs/hhj032.
7. See, e.g., Bacon, C. (2013). “Behavioral finance and investment policy statements.” Journal of Wealth Management, 16(2), 8-15. This article discusses how a well-crafted IPS can help investors overcome behavioral biases such as loss aversion and overconfidence. See also, e.g., Kinniry, F. M., & Buckley, J. (2017). “The role of investment policy statements in mitigating behavioral biases.” Journal of Financial Planning, 30(6), 142- 153. This article highlights the importance of IPS in mitigating behavioral biases such as confirmation bias and anchoring bias. See also, e.g., Statman, M. (2011). “Behavioral finance and investment policy statements.” Journal of Behavioral Finance, 12(2), 63-71.
8. Bağcı & Soylu (2024) examine a high-frequency rebalancing algorithm that uses volatility information to decide when to rebalance. Their results show that such a strategy can outperform standard periodic rebalancing (and presumably buyandhold) — supporting the idea that volatility harvesting can improve long-term returns. Bağcı, M., & Soylu, P. K. (2024). Optimal portfolio selection with volatility information for a high-frequency rebalancing algorithm. Financial Innovation, 10, Article 107. https://doi.org/10.1186/s40854-023-00590-3. Farago & Hjalmarsson (2022) provide empirical evidence that small, periodically rebalanced portfolios often outperform the market over long horizons. This supports the proposition that systematic rebalancing helps preserve diversification and avoids the concentration risk that can erode longterm returns in buyandhold portfolios. Farago, A., & Hjalmarsson, E. (2022). Small rebalanced portfolios often beat the market over long horizons. The Review of Asset Pricing Studies, 13(2), 307–342. https://doi.org/10.1093/rapstu/raac020. The CFA Digest (2016) offers a theoretical and empirical overview of “volatility harvesting,” showing that portfolios using equalweighting plus trigger-based rebalancing often beat market-capitalization-weighted portfolios, with lower risk and higher riskadjusted returns than buyandhold alternatives. CFA Institute. (2016). Volatility harvesting in theory and practice. CFA Digest Summary. https://www.cfainstitute.org/-/media/documents/support/programs/cfa/volatility-harvesting-in-theory-and-practice.ashx.
This article is for educational purposes only. It should not be construed as financial, legal, tax, or investment advice, nor as a recommendation to implement any specific strategy, product, or investment. Consult with a qualified financial professional before making investment decisions.
