A behavioral finance approach to Hedge Funds. A review and empirical tests of biases and errors

Abstract

The author describes the characteristics of hedge funds as an alternative investment vehicle including their history, legal structure, regulation and various investment strategies. Behavioral finance is a cognitive psychological approach to financial decisions. The author introduces the three themes of behavioral finance including heuristics, framing and inefficient markets following by an explanation of how they might effect financial practitioners. In a discussion he proposes that hedge fund managers, due to the specific characteristics of hedge fund operations, are more prone to suffering from cognitive biases undetected and that the committed errors may have far greater consequences than in other fields of investments. To back up his arguments the author gives the example of the fall of LTCM and shows how some of their bad decisions were based on biases that are explained by behavioral finance.