mutual fund investors

Unveiling the psychology of mutual fund investors: Understanding behavioral biases

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Mutual funds have become increasingly popular investment avenues for retail investors in India. In April 2024, assets under management (AUM) of the mutual fund industry stood at Rs. 57,25,898 crore, with an investor base of over 128 million. However, mutual fund investments are subject to various behavioral biases that influence investors’ decision making. Understanding these biases can help investors make more rational investment choices.

Loss aversion bias

Many mutual fund investors display ‘loss aversion’, where they overly focus on avoiding losses rather than earning gains. This results in investors holding on to underperforming investments too long, hoping to recover losses. They also ‘chase returns’, pouring money into funds after a period of high returns, despite the funds being riskier or having lower future return potential. To counter loss aversion, investors should objectively evaluate funds based on fundamentals, ignoring short-term fluctuations.

Recency bias

Investors often display ‘recency bias’, placing higher significance on recent events while predicting future performance. For instance, investors may exit equity funds after a market crash, assuming the downturn represents a long-term trend. Or they may invest in a sector fund after a temporary surge, ignoring the fund’s historical performance. To avoid recency bias, investors should take a long-term view, focusing on fund track records over entire market cycles.

Home bias

Many Indian investors display ‘home bias’, preferring to invest only in Indian mutual funds despite lower correlations and diversification benefits from global funds. This home country bias results in concentrated portfolios vulnerable to domestic slowdowns. Investors should recognize that reasonable allocations to international funds can reduce risk through diversification.

Herding effect

The ‘herding effect’ bias causes investors to follow the crowd rather than objectively assessing fundamentals. When a fund delivers high returns, many investors pour money into it, inflating the fund’s size and reducing future returns. Selling begets more selling during downturns for the same reason. Rather than chase past returns or flee downturns, investors should stick to asset allocation, rebalancing periodically.

Overconfidence

Many investors are overconfident in their ability to time the market or select winning funds. This results in excessive trading, churning of portfolio holdings and lower realized returns due to transaction costs. Investors should opt for systematic investments through SIP, patiently holding funds over long periods. roper asset allocation and periodic rebalancing helps overcome emotional decision making.

Conclusion

Understanding behavioral biases is key for mutual fund investors to counter irrationality and take well-informed investment decisions. Loss aversion, recency bias, home bias, herding effect and overconfidence are key biases that investors must recognize and mitigate through disciplined behavior. Robust investment processes, systematic investments and a long-term perspective can help investors achieve their financial goals through mutual fund investing.

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