Behavioural finance: How fear and greed impact risk management in investing

Posted On: 28 August 2024

Investing in mutual funds can be a convenient and affordable way to potentially build wealth over time. However, like all investments, it comes with risks.

Many of these risks are linked to market and economic forces that are beyond an individual investor’s control. However, an investor’s emotions and biases can also influence investment risks and outcomes.

In particular, fear and greed can play a significant role in shaping investment decisions. These emotions can cause you to either take on too much risk or avoid it entirely, leading to decisions that can hurt your investment returns.

This article tells you more about how fear and greed can influence mutual fund investing and ways to counter these.

Table of contents

Behavioural finance in mutual fund investing
Understanding fear in mutual fund investing
Understanding greed in mutual fund investing
Impact of fear and greed on risk management
How to counter fear, greed and other emotions when investing

Behavioural finance in mutual fund investing

Behavioural finance combines the principles of psychology and finance to understand how investors make decisions. Traditional finance theories assume that investors are rational and always make decisions that can optimise their return potential. However, behavioural finance acknowledges that emotions and cognitive biases often lead to irrational decisions. Some of the emotions that come under the realm of study are overconfidence, loss aversion, herd mentality, confirmation bias, regret aversion and the various heuristics or mental shortcuts that people take when making decisions or processing information.

Understanding fear in mutual fund investing

Fear is a powerful emotion that can have a profound impact on your mutual fund investments. One way it manifests is as the fear of losing money. This fear can lead to overly cautious decisions, such as selling off your mutual fund units during a market downturn or avoiding higher-risk funds altogether.

For example, imagine you've invested in an equity mutual fund. If the stock market experiences a sudden drop, fear might prompt you to redeem your units quickly to avoid further losses. However, this decision could result in selling at a loss and missing out on potential market recovery, which could lead to long-term gains.

Fear can also cause you to stick to low-risk, low-return mutual funds, such as debt funds because they are less risky. While these funds may keep your capital relatively stable, they might not provide the growth needed to meet your long-term financial goals.

Understanding greed in mutual fund investing

On the other side of the spectrum is greed, another powerful emotion that can drive investors to chase higher returns. In mutual fund investing, greed often leads to taking on excessive risks in pursuit of higher gains.

For instance, during a bull market, you might be tempted to invest heavily in equity mutual funds, hoping to capitalise on rising stock prices. While equity mutual funds have the potential for higher returns, they also come with higher volatility. If your greed drives you to overexpose your portfolio to equities, you might face losses during a market correction.

Greed can also lead you to invest in sector-specific funds that have been performing well, without considering the risks associated with lack of diversification.

Greed can also lead you to switch between mutual funds frequently, trying to chase the best-performing funds. This can take your focus away from your long-term goals. Moreover, frequent and large redemptions can increase your tax burden.

Impact of fear and greed on risk management

Both fear and greed can lead to poor risk management decisions. When fear dominates, investors may become too risk-averse, missing out on potential gains by avoiding investments that could offer higher returns. On the other hand, when greed takes over, investors may take on too much risk, exposing themselves to significant losses if the market turns against them.

Effective risk management requires a balanced approach that considers both the potential rewards and risks of an investment. However, when emotions like fear and greed come into play, this balance can be disrupted, leading to irrational decisions.

For example, an investor driven by fear might allocate most of their portfolio to low-risk, low-return assets like fixed deposits. While this strategy may preserve capital, it may not provide the growth needed to achieve long-term financial goals, such as retirement.

Conversely, an investor driven by greed might allocate too much of their portfolio to high-risk assets such as highly volatile market segments or emerging avenues that are attracting a lot of buzz but are yet to stand the test of time. While this strategy could lead to higher returns, it also increases the likelihood of significant losses, especially if the market experiences a downturn.

How to counter fear, greed, and other emotions when investing

Given the significant impact that fear, greed, and other behavioural biases can have on your mutual fund investment decisions, it’s essential to develop strategies to counter these influences. Here are a few tips:

Stick to a plan: One of the most effective ways to manage emotions in investing is to have a well-thought-out investment plan. This plan should outline your financial goals, risk tolerance, and mutual fund selection strategy. By sticking to this plan, you can avoid making impulsive decisions based on fear or greed.
Systematic Investment Plans (SIPs): SIPs can be an effective way to counteract the effects of fear and greed in mutual fund investing. By investing a fixed amount regularly, SIPs help you avoid the temptation to time the market. This disciplined approach reduces the impact of short-term market fluctuations on your investments and allows you to benefit from rupee cost averaging.
Diversify your mutual fund portfolio: Diversification is key to managing risk in mutual fund investing. By spreading your investments across different types of mutual funds, such as equity, debt, and hybrid funds, you can reduce the impact of any one fund’s poor performance on your overall portfolio. This strategy can help mitigate the effects of fear and greed by providing a balanced approach to risk management.
Educate yourself: By educating yourself about mutual funds, market trends, and common behavioural biases, you can make more informed decisions. This can help you recognize when fear or greed is influencing your choices and take steps to counteract these emotions.
Hold a long-term view: Mutual fund investing should be viewed as a long-term endeavour. By focusing on your long-term financial goals rather than short-term market movements, you can avoid the emotional rollercoaster that often accompanies investing. Remember that markets will always experience ups and downs, but a well-diversified portfolio has the potential to grow over time.
Seek professional advice: If you find it difficult to manage your emotions while investing, consider seeking advice from a financial advisor. A professional can provide an objective perspective, helping you stay focused on your financial goals and avoid making decisions based on fear or greed.

Conclusion

Fear and greed are powerful emotions that can significantly impact risk management in mutual fund investing. While these emotions are natural, they can lead to irrational decisions if not managed properly. By understanding the role of behavioural finance and employing strategies like SIP investment, diversification, and long-term planning, you can counter the effects of fear, greed, and other behavioural biases. This will help you make more informed investment decisions, ultimately leading to better financial outcomes.

FAQs

How does fear impact mutual fund investment decisions?

Fear can cause investors to make overly cautious decisions, such as selling off mutual fund units during a market downturn or avoiding avenues that offer high return potential altogether (because risk and reward go hand-in-hand in investing). This can lead to missed opportunities for growth.

How can I avoid making investment decisions based on greed?

To avoid making decisions driven by greed, it’s important to stick to a well-thought-out investment plan and diversify your portfolio. Additionally, using SIPs can help you invest a fixed amount regularly, despite market conditions, reducing the temptation to chase short-term gains.

What is the role of behavioural finance in mutual fund investing?

Behavioural finance studies how psychological factors, such as emotions and cognitive biases, influence investment decisions. Understanding these factors can help investors make more rational and informed decisions, improving their long-term investment outcomes.

How can SIPs help counter behavioural biases in mutual fund investing?

SIPs help counter behavioural biases by encouraging disciplined, regular investing, which reduces the impact of short-term market fluctuations. By investing a fixed amount regularly, regardless of market conditions, SIPs help investors avoid the pitfalls of fear and greed.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.