Behavioral Funds

What Are Behavioral Funds?

Behavioral funds are a category of mutual funds that use behavioral finance as a
basis for their investment strategy.

Managers of behavioral funds believe that human behavior leads to certain

market inefficiencies. Investors can take advantage of these market inefficiencies
to get a superior return. Behavioral funds are seeing increased interest among
investors and academics because their underlying principle opens up
significant research and analysis opportunities; this allows for a wide variety of
investment strategies to be employed in fund creation.

KEY TAKEAWAYS

 Behavioral funds are a category of mutual funds that use behavioral

finance as a basis for their investment strategy.
 Managers of behavioral funds believe that human behavior leads to certain
market inefficiencies that can be taken advantage of to get a superior
return.
 Behavioral finance is the study of human behavior, practice, and
tendencies as they relate to finance, economics, and investment decision-
making.
 Behavioral funds seek to take advantage of pricing anomalies that may
exist in the continuum between rational investors and irrational investors.
Understanding Behavioral Funds
The basis of behavioral funds is behavioral finance. Behavioral finance is a
relatively new field that combines behavioral and cognitive psychological theory
with conventional economics and finance. It attempts to provide explanations for
why people make irrational financial decisions. In other words, behavioral finance
is the study of human behavior, practice, and tendencies as they relate to
finance, economics, and investment decision-making.

Behavioral funds seek to take advantage of pricing anomalies that may exist in

the continuum between rational investors and irrational investors by tracking their
sentiment and decision-making. For example, during periods of market downturn,
investors tend to have a herd mentality; they shy away even from investments
that are fundamentally sound, driving down their prices. It might be said that
these investors are driven more by their human emotions than by investment
fundamentals.
For instance, during the U.S. stock market downturn between 2007 and 2009,
many emotion-influenced investors fled the stock market. This created an
opportunity for some bargain buys for savvier investors. Behavioral funds are
intended to take advantage of these kinds of opportunities to buy stocks, and
other investments that other investors avoid, at a discounted price. However, it is
not clear whether behavioral funds using such strategies have actually
outperformed the market.

Special Considerations
The investment strategies of behavioral funds may pursue similar themes.

Finding Irrational Biases in the Market

Irrational biases in the market may exaggerate the impact of negative news—
beating the stock prices to much deeper levels (for low-cost buying opportunities)
—or overplay the impact of positive news by pumping the stock prices to higher
levels (for high-cost short selling opportunities).

Identifying Stocks With Unexpected Indicators

Behavioral funds attempt to identify those stocks that temporarily having lower or
higher than expected indicators (for example, price-to-earnings ratio). Comparing
these against other fundamentals, like a company’s credit risk and valuations,
may indicate better investment picks in a timely manner.

Temporarily Underperforming Stocks

Behavioral funds may also invest in stocks that may have temporarily
underperformed relative to the overall market based on irrational exuberance, but
continue to have strong fundamentals. 

Profitable Opportunities
Finally, behavioral funds may seek to Identify stocks based on other potential
developments that can lead to profitable opportunities, like from an
expected share buy-back or stock split.