The Use of Behavioral Finance in Hedge Fund Management

Behavioral finance is pervasive throughout the hedge fund industry, according to the Wharton School at the University of Pennsylvania. Hedge fund managers are extremely strategic, very aware of their surroundings and are able to identify patterns and opportunities in the financial markets that the average investors do not see. Subsequently, the major tenets of behavioral finance, which are market strategies and psychology, come naturally to many hedge fund managers.

The hedge fund industry is a highly competitive arena where only the top managers endure. Managers must rely on past investment history in addition to relationships with investors to raise capital in the financial markets for investment funds. Multiple hedge fund managers are often vying for the same capital from investors and may rely on certain behavioral finance techniques to predict or interpret investor preferences, according to the Wharton School.

Hedge funds have strategies attached to them. Market strategies are another component to behavioral finance. Hedge fund managers apply behavioral finance in order to take advantage of inefficiencies in the markets, according to a University of Florida report titled "Behavioral Finance." A market inefficiency represents a market condition where the true value of financial securities is not currently evident in the price for that investment. A hedge fund manager applying behavioral finance seeks to seize these inefficiencies and profit from them.

A hedge fund manager often exhibits characteristics that exude confidence and these individuals tend to have a predisposition to risk. According to the University of Florida report, these tendencies could interfere with successful hedge fund management as it relates to behavioral finance. A fund manager's arrogance could impair his judgment, for instance. It could cause a fund manager to bypass one of the fundamentals of investing, diversification, to instead remain narrowly focused on a strategy or asset class.

Not all market participants believe that there are inefficiencies in the financial market from which to profit. Economist Eugene Fama of The University of Chicago believes that the markets are efficient, according to a 2010 article in Institutional Investor titled "Using Behavioral Finance to Better Understand The Psychology Of Investors." Market efficiency suggests that a financial security's price truly reflects all of the present factors that could possibly affect a stock's value. In an efficient market, there is no undervalued stock or overvalued stock from which to profit.