Understanding behavioural biases in decision-making regarding your mutual fund investments

Investing is as much about understanding the markets as it is about understanding oneself. The world of behavioural finance has much to say on this topic. Behavioural finance is a relatively new field of study that merges psychological theories with conventional finance to ascertain why people make irrational financial decisions.

Instead of assuming that individuals always act rationally – as in traditional finance models, behavioural finance assumes that there are numerous behavioural biases of individuals that affect their decision-making process. This article explores the intriguing realm of behavioural biases, particularly focusing on mutual fund investments.

By understanding what these behavioural biases are, investors can make more informed choices and experience potentially better financial success.

• Table of contents

1. Behavioural biases in mutual fund investment decisions
2. Managing behavioural biases

Behavioural biases in mutual fund investment decisions

Mutual funds are a popular investment avenue for many reasons. However, while mutual funds offer the promise of diversification and professional management, the investors’ decisions to buy, hold, or sell the funds are often swayed by psychological biases.
Let’s take a closer look at some of the common behavioural biases at play:

• Loss aversion: This bias refers to the human tendency to fear losses more than enjoy gains. Due to this, investors might hold onto underperforming mutual fund schemes longer than necessary, hoping to break even. The psychological pain of realising a loss often outweighs the logical decision to sell and potentially reinvest elsewhere. This may result in holding onto a declining fund for longer than necessary, waiting for it to rebound, thereby missing out on other potentially lucrative investment opportunities.

• Mental accounting: Investors often treat money differently based on its source or intended use – an error known as mental accounting. Mental accounting can be particularly tricky with mutual funds. For instance, gains from a mutual fund might be viewed as "free money" and spent unwisely, whereas the principal investment is treated with more caution. This kind of mental separation can lead to inconsistent investment decisions where certain portions of the investment are not optimised for the ideal return potential.

• Recency bias: Mutual fund investors often fall for recency bias, where recent events or trends unduly influence decisions. If a particular sector or type of fund has performed well recently, they might assume it will continue to do so and invest more heavily in it. Conversely, if a fund has underperformed in the recent past, they might avoid it, even if its long-term prospects are solid.

• Confirmation bias: Once an investor has chosen a mutual fund, there is a tendency to seek out information that validates that choice and ignore data that contradicts it. This can lead to an overconfidence in the fund's potential and a reluctance to reconsider the investment, even when signs suggest it might be time to re-evaluate.

• Herd mentality: This bias manifests when investors follow what everyone else is doing, rather than basing decisions on independent research or their risk profile. If there's a buzz around a particular mutual fund and many are investing in it, others might jump on the bandwagon, fearing that they are missing out. Conversely, if many are selling a particular fund, it might trigger a panic sell-off, even if the fund's fundamentals remain strong.

By understanding these behavioural biases and their nuances, mutual fund investors can be more vigilant and make decisions that align with their investment goals and risk tolerance. Awareness, education, and sometimes even a contrarian mindset, are crucial to understand the world of mutual fund investing. .

Managing behavioural biases

Awareness is the first step towards overcoming biases. Recognising the behavioural biases of individuals allows one to guard against them or sometimes even employ them advantageously.
Here are some ways to effectively manage behavioural biases:

• Recognise, reflect and correct: One of the first steps to combat behavioural biases is self-awareness. By identifying which biases are most likely to impact them, investors can begin to notice patterns in their decision-making and take corrective actions. Knowing one’s behavioural biases can also work to an investor’s advantage. For instance, if an investor recognises their tendency towards loss aversion, they can set stricter rules about when to sell a mutual fund, ensuring they stick to a rational decision-making process.

• Diversify investments: Diversification can act as a safeguard against the fallout from some behavioural biases. If loss aversion makes an investor reluctant to sell a declining mutual fund scheme, a diversified portfolio can help mitigate the impact of potential losses.

• Consult with professionals: Financial advisors and mutual fund managers are not immune to behavioural biases, but their professional training often equips them to manage these biases more effectively. Engaging with professionals can provide an objective perspective, helping to counteract personal biases.

Conclusion:

In the complex process of investing, the steps may not be always logical. Behavioural investing, with its focus on understanding the behavioural biases that influence decisions, offers profound insights into the human side of financial markets. By recognising and addressing these biases, investors can harness the full potential of their mutual fund portfolios, making choices that align more closely with their financial goals.

FAQs:

How do behavioural biases impact mutual fund investments?

Behavioural biases can lead investors to make hasty decisions, like selling during market downturns or buying into trending funds without proper research. These biases can negatively affect returns.

What is confirmation bias?

Confirmation bias occurs when investors seek information that confirms their existing beliefs about a mutual fund, ignoring contrary evidence. This can lead to poor investment decisions.

How can I mitigate behavioural biases?

To mitigate biases, consider adopting a systematic investment plan, diversifying your portfolio, and seeking advice from financial professionals. Sticking to a well-thought-out investment strategy can help counteract impulsive decisions.

What is the role of self-awareness in avoiding behavioural biases?

Self-awareness is crucial in recognizing and addressing behavioural biases. Regularly reviewing your investment decisions and being mindful of emotional triggers can help you make more rational choices and enhance your mutual fund investment outcomes

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.