How Hedge Funds Remove the Psychology of Investing

If you don’t want to research investments and managing a portfolio yourself, go for an index fund. Index funds will save you time and effort.

In order to find out more information about index funds, we went to the investment management company, Willow Creek Capital Management.

According to a portfolio manager from Willow Creek, investing in index funds has another key advantage. Investing in hedge funds can help you get better returns by removing the psychological biases that individual investors must overcome to manage a portfolio effectively.

By comparison to the average equity investor, who achieved an average annual return of just 3.66%, from 1985 to 2018, the S&P 500 returned 10.35% per year on average.

That explains the huge gap between individual investors and the S&P 500 index.

Experts from Willow Creek Capital Management, in affiliation with the University of Berkely, point out that individual investors suffer from psychological biases such as:

·         Loss aversion: Investors sell at sub-optimal times and invest in lower risk equities, which end up producing lower returns due to fear of losing money.

·         Narrow framing: Investment decisions are made without considering the context of a total portfolio.

·         Mental accounting: Due to mentally separating money into different buckets, individuals take undue risk in one area while avoiding rational risk in another.

·         Anchoring: Instead of adapting to a changing market, they are focusing on the past

·         Unrealized lack of diversification: Despite investing in highly correlated assets, they think that the portfolio is diversified

·         Irrational optimism: Experts from Willow Creek Capital Management claim that individuals also believe that good things will happen to them and bad things will happen to others.

·         Herding: Copying the typical behavior of others, buying high and selling low.

·         Regret: Letting previous errors affect the way of making new decisions.

Experts from Willow Creek Capital Management claim in their research publications that the psychological hurdles individual investors face can be overcome with buying an index fund, or building a portfolio of index funds. 

As it is understandable that the index fund will practically match the index's return, an index fund is much easier to buy and hold. When trying to construct and organize a portfolio of individual assets or actively managed mutual funds, the before mentioned can help control loss aversion and a bunch of other biases that pop up. For more information, follow Willow Creek .