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Hedging on human behavior

Amy Scott Dec 4, 2006

KAI RYSSDAL: They used to be the preserve of the ultra-rich. But hedge funds have become more mainstream over the past decade or so. Ten years ago there was about 60-billion dollars in them. Today, it’s around one-point-two trillion. Yet, as the number of hedge funds has grown, their profits have started shrinking. So fund managers are trying all sorts of new tactics to set themselves apart. Marketplace’s Amy Scott reports.

AMY SCOTT: Last month the hedge-fund manager DKR Capital launched a new fund. It’s aim? To capitalize on the quirks of the human psyche. The concept is known as behavioral finance.

Richard Thaler at the University of Chicago is considered the father of the field. He also runs a handful of mutual funds based on his theories. Thaler says traditional finance teaches us that the markets are rational and efficient. But there’s a lot of money to be made assuming the opposite.

RICHARD THALER: Real people sometimes make mistakes, sometimes are emotional. And behavioral finance starts with the assumption that people are people, and then investigates what happens in markets when real people are doing the buying and selling.

One thing that happens is that stock analysts can be overconfident. Let’s say an analyst is following a paper clip company that’s been losing money. Then the company turns a corner. But the analyst is too married to his own theory to notice. That’s when a fund like Thaler’s buys the stock — when it’s still cheap but poised to rise.

THALER: We try to find situations where there are biases that we would be subject to as well if we tried to play the game the same way as everyone else.

The approach is catching on in mainstream investing. In addition to DKR’s new hedge fund, JP Morgan offers a handful of behavior-based mutual funds. The research firm Market Semiotics employs behavioral finance to predict market movements. Roger Ehrenberg heads the financial information service Monitor 110.

ROGER EHRENBERG: People are groping for alpha right now.

Alpha is finance speak for beating the market. It’s what hedge funds in particular are all about. Ehrenberg says hedge-fund managers can only justify their high fees by delivering a better return than their investors could get elsewhere.

EHRENBERG: Which is why some of the smartest minds are going into hedge-fund management, because it’s that kind of intelligence and flexibility to think outside the box and to devise ways of making money that everybody else isn’t already doing that’s so challenging.

Behavioral finance is part of a larger trend that’s sweeping Wall Street. Money managers are increasingly hiring PhDs and creating computer models to find hidden patterns in the markets. The inventor and futurist Ray Kurzweil is launching a new hedge fund using artificial intelligence to detect market patterns. Chris Cutler analyzes hedge funds for investors. He sees this hitch.

CHRIS CUTLER: When something works, everyone else will figure it out within a short period of time. So it may make money over the next year. And then it may be flat the next year or actually lose money.

Richard Thaler, the behavioral finance pioneer, has a mixed investment record. His behavioral growth fund underperformed comparable mutual funds two out of the last five years. But he says it’s those mixed results that keep everybody else from trying it.

THALER: The deep irony and cruelty in this business is that for a strategy to work it really has to not work some of the time.

Those behind DKR’s new hedge fund and other proponents of behavior-based investing hope that it works most of the time.

In New York, I’m Amy Scott for Marketplace.

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