Ever heard of a fund that takes investment decision based on irrational behaviour of the investors? Well, maybe you'd think that that is what all smart traders do instinctively but now there's a fund in Japan that follows this as a stated strategy. Most of the dominant economic theories are based on the belief that the financial markets are efficient—in other words, that all relevant information is reflected in asset prices and this is done in a rational manner. But markets are not always efficient and do not always follow such set patterns. Investor confidence and psychology also has an important role to play in the behaviour of markets. This is now more widely accepted and has opened up a whole new discipline called behavioural finance.
Behavioural Finance is a blend of psychology and economics, which concerns itself with individual and collective behaviour in different financial situations. It aims to identify 'irrational' financial behaviours. While investment decisions are normally based on economic and financial models, such models assume that people would behave 'rationally'. However as humans we all suffer from fear, greed, regret, overconfidence etc, that influences our decisions, be it financial or others. This leads to irrational behaviour among us. Individually we are subject to a wide range of systematic 'irrationalities' as our emotions often distort our reasoning, making it faulty.
Mutual Funds are also recognising the role of human emotion or irrationality and are trying to factor it in their functioning. In Asia ABN-AMRO Behavioural Finance Japan Fund, which was launched in February 2001, was the first fund to explicitly recognise the importance of human emotions in the behaviour of financial markets. The fund is based on the insights from behavioural finance with criterion of picking stocks on emotional and behavioural patterns present in the stock markets. Thus it tries to exploits the irrationality of investors for profit.
The fund works on the Behavioural Finance model, which is computer-generated. Factors such as image bias, overconfidence, overreaction are quantified using the model. Every factor is linked to a financial ratios or measurements that can be done on data. The model after processing shows a list of stocks that have the highest potential.
Also the fund varies its approach. For example in one time period the over confidence factor could be very important, while in the next period it could be the image bias (attractive valuation) etc. In other words the stocks that the model selects are the ones that have been undervalued for emotionally driven reasons rather than rational reasons. While this as a concept may be developing world over, it'll take some time for our domestic fund industry to offer such a fund.