Behavioral Biases

The hedge fund universe’s constituents generally exhibit an impressive arsenal of idea generation and research talent. This, overlaid with position-specific and/or portfolio-level risk mitigation, represents what most hedge funds are all about. The risk mitigation overlay toolbox often includes, for example: diversification, paired positions, systemic and/or sector hedges, market neutrality, and targeted risk calibration. Hedge fund managers and investors have sought comfort in these risk mitigation tools in their quest for absolute returns and thereby protect at least part of their portfolio allocation from broad market drawdowns and dislocations. Unfortunately, and as recent history demonstrated, none of the risk mitigation tools offer a guarantee to absolute returns. This article seeks to demonstrate that dwelling on a risk mitigation overlay as described above to construct hedge fund portfolios, coupled with two key missing ingredients, only further alienates the hedge fund mandate from the concept of absolute returns and the protection of precious capital.

The first key ingredient is to abstain from surrendering to two particular behavioral biases, i.e., overconfidence and the disposition effect. The second key ingredient consists in the failure to distinguish between risk management from risk mitigation.