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.

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.