Investors are often their own worst enemies
In traditional finance, the “rational actor” is a mythical creature who invests based solely on the optimisation of risk-adjusted returns. In this world, hedge funds are judged purely by their ability to generate alpha – excess return over a benchmark – after accounting for their often steep fee structures. However, the reality of the South African investment landscape and indeed the global one, is far messier. Investors are not calculators; they are collections of narratives, anxieties, desires, cognitive shortcuts and a social species subject to the whims and influences of others.
Investors frequently “fall foul” of their own psychology and they are often their own worst enemies. For many, hedge funds serve as a behavioural circuit breaker. We invest in them not because they are the optimum path to wealth, but because they appease the biases that would otherwise lead us to make catastrophic mistakes with a traditional “long-only” portfolio. This is why Vanguard, in a landmark paper in 2014, suggested that the greatest value that a financial planner can add to a client’s portfolio is not necessarily through astute asset allocation or insightful fund selection, but rather through behavioural coaching. Vanguard quantified the value added through behavioural coaching at 1.5% pa, about half of the total value they calculated a financial advisor can add to a client’s portfolio.
Given the nature of hedge funds and the role they play in a client’s portfolio, it could be argued that hedge funds provide great support to a financial advisor’s behavioural coaching efforts, as they help to address some of the most fundamental biases that afflict investors. Outlined below are six key biases that hedge funds help address.
The pain of loss: overcoming loss aversion
Arguably, the most dominant force in investor psychology is loss aversion. As pioneered by Daniel Kahneman and Amos Tversky, the pain of a loss is psychologically twice as powerful as the joy of an equiva-lent gain.
In a standard equity fund, the investor is fully exposed to the “beta” of the market; when the JSE or the S&P 500 drops 20%, the investor feels every cent of that decline. Hedge funds, particularly long-short equity or market neutral funds, offer a psychological sedative. By using short positions to hedge market downside, these funds aim to dampen volatility.
An investor might intellectually know that a low-cost index fund may outperform a hedge fund over 20 years. However, if that investor is so sensitive to loss that they would panic-sell during a market correction, the “optimum” index fund becomes a liability. By “appeasing” loss aversion through a smoother return profile, the hedge fund helps the investor stay the course. By investing in a hedge fund, the investor isn’t necessarily buying outperformance; they are buying the emotional fortitude to remain invested.
The comfort of complexity: beating the complexity bias
As humans, we have a strange, counter-intuitive tendency called complexity bias. We often believe that complicated solutions are inherently better than simple ones, especially when dealing with complex systems like global markets.
A simple portfolio of diversified low-cost funds feels “too easy” to many high-net-worth individuals, as well as investors who may be looking for something “more”. For wealthier investors, there is a certain cognitive dissonance in believing that one’s hard-earned wealth can be managed by a strategy that can be explained in a single sentence, and the same often applies to those trying to grow their wealth.
Hedge funds, with their sophisticated use of derivatives, leverage and arbitrage, provide a narrative that matches the perceived gravity of the investor’s situation. The very things that make hedge funds opaque – the “black box” nature of the strategy – appeal to the bias that a “special” problem requires a “specialist” tool. Investing in a hedge fund allows the investor to feel that they are taking a more sophisticated, proactive approach, even if the net result doesn’t always justify the complexity.
Taming the green-eyed monster: managing regret aversion
Regret aversion occurs when investors fear making a decision that turns out poorly, or equally, fear missing out on a trend that others are profiting from. This often manifests as “herding”.
In South Africa’s relatively concentrated market, the fear of being “wrong and alone” is high. Hedge funds often provide access to “alternative” sources of return – whether through shorting the market or investing in more unusual opportunities like distressed debt or niche commodities. When the JSE is flat or declining, but a specific hedge fund manager is making a “macro play” on currency fluctuations, it provides a hedge against the regret of being tied solely to the South African local index.
Financial planners and investors often use hedge funds to ensure they have a “satellite” in their portfolio that might perform when nothing else does. It isn’t necessarily about the total return of the portfolio; it’s about ensuring there is always a “winner” somewhere, so that when a financial planner has to report to a client, or a client receives their investment statement, there will be at least one element of the portfolio that offsets the psychological weight of the “losers”.
The illusion of control and the active management trap
Financial planners and investors (especially those who have been successful in their own careers) often suffer from an illusion of control. They believe that through superior skill, insight or the selection of a “star” manager, they can influence the outcome of their investments.
Hedge funds are the ultimate expression of active management. Unlike a passive fund that accepts whatever the market gives, a hedge fund manager promises to navigate, pivot and exploit. By investing in a hedge fund, the investor feels that they have exercised control by choosing a “pilot” rather than just drifting with the current. This appeases the action bias – the urge to “do something” during times of uncertainty.
If the market is volatile, “doing something” (like investing in a fund that can go short) feels safer than “doing nothing” (staying long), even if the costs of that action erode the very returns the investor seeks.
Framing and the “silo” effect: mental accounting
Behavioural finance teaches us that we often fall foul of the cognitive mistake of mental accounting, where we treat money differently depending on where it sits or what “label” we give it. Investors often view their “core” portfolio (often made up of index funds, or long-only active equity funds, or even bonds) and their “satellite” portfolio (hedge funds or private equity) in different mental silos.
They might be highly price-sensitive regarding the fees on their core portfolio but perfectly willing to pay the often materially higher fees for a hedge fund.
Why? Because the hedge fund is framed as “alpha” or “absolute return”. By categorising the hedge fund as a separate species of investment, the investor avoids the painful comparison of net returns against a simpler or “cheaper” benchmark. This framing allows them to hold a high-cost instrument because it serves a specific “purpose” in their mind – such as “downside protection” or “uncorrelated growth” – regardless of whether it effectively achieves that purpose better than a cheaper alternative.
Availability and recency bias: the lure of the “big win”
We are naturally drawn to stories of spectacular success. Availability bias causes us to overestimate the probability of events that are easy to remember. The narrative of the hedge fund manager who “called the 2008 crash” or “shorted the rand” at the perfect moment looms large in the investor’s mind. Even if the average hedge fund underperforms the market over a decade, the possibility of catching that outlier performance is intoxicating. This is similar to why people buy lottery tickets; the “optimum” move is to keep the money, but the “behavioural” move is to buy the hope of a transformative outcome.
Investing for the human, not the spreadsheet
If we look only at the data, the argument for a heavy allocation to hedge funds can potentially falter under the weight of high fees and inconsistent performance. However, if we look at the investor, the picture changes. As renowned behavioural finance expert Meir Statman observed, financial planners should see themselves as “investor managers” rather than “investment managers”. With this insight in mind, it is clear that hedge funds can support financial planners in their behavioural coaching efforts by helping to solve for the human frailties that investors inevitably fall foul of. Hedge funds offer investors the opportunity to:
- Stop themselves from selling in a panic (loss aversion).
- Feel like they are doing something sophisticated (complexity bias).
- Gain a sense of agency in an unpredictable world (illusion of control).
In this light, a hedge fund is not just a financial product; it is a behavioural management tool. If paying a higher fee for a hedge fund prevents an investor from abandoning their long-term strategy during a market crash, then the fund has provided value – not necessarily through superior market returns, but by delivering “behavioural alpha”.
The bottom line
The goal of investing is to reach a financial destination. If a potentially “sub-optimal” vehicle is the only one the investor is willing to stay in for the whole journey, then for that specific human, it becomes the only rational choice. This is not to say that hedge funds are “sub-optimal”, but we don’t just invest our money; we invest our egos, our fears and our hopes. Hedge funds, for better or worse, are designed to try to house them all.
* As published in the Blue Chip 2026 Hedge Fund guide.
