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How do mutual funds help in avoiding investment biases?

ICICIdirect 8 Mins 25 Jan 2024

Direct equity investment is awesome if you look at historic returns. You have the potential to earn alpha - obviously, the risks are also high. Direct equity investment is about discipline, and most investors are unable to master it. Therefore, they are unable to make good returns from the market. 

Another problem is investment biases that are part of investors' journey. Investment bias refers to systematic patterns of deviation from norm or rationality in decision-making around investing. These biases can influence investors to make suboptimal decisions based on emotions, cognitive errors, or other psychological factors. 

One of the solutions is to start investing via mutual funds, as they may help you avoid common investment biases. In this article, we talk about investment bias and how mutual funds can help you avoid them.

Recency Bias

The first bias we take is recency bias. It is your tendency to give more weight to recent events and assume that current trends will continue indefinitely. This bias can lead to suboptimal investment decisions, such as buying high during bull markets and selling low during bear markets.

Let us understand with an example. In the last couple of months, the market has been moving north, and many investors believe that the market will continue to do so. You may, because of recency bias, put in everything you have in the market without a fall-back plan. When the market correction happens - which will at some point - they are not left with any money to buy at the lower levels. 

During the Harshad Mehta time, the same thing happened. Investors saw the market rising and everyone making money. They assumed this would never end and continued investing in equity without thoroughly assessing the underlying company's fundamentals. When the scam was exposed, the market crashed, causing substantial losses for those who invested based on recent performance.

Herd Mentality

Herd mentality refers to the tendency where you follow the crowd or mimic the actions of a larger group, even if those actions might not be based on careful analysis or rational decision-making. This behavior often arises from the fear of missing out (FOMO) or the assumption that the group possesses superior information. Herd mentality can lead to market bubbles, speculative excesses, and mispricing of assets.

Let's explore herd mentality in the context of options trading with an example. Suppose there is a popular tech stock, XYZ Ltd., that has experienced a significant price increase over the past few weeks, and many investors are optimistic about its future. Several traders have been buying call options on the company in the hope of profiting from a further increase in the stock price.

Here's how herd mentality might manifest in this scenario:

  • Traders, influenced by the rising price of XYZ Ltd. and the actions of others in the market, start buying call options without conducting their own thorough analysis. 
  • As more and more traders join the trend, the demand for call options on XYZ Ltd. increases substantially. It can lead to overcrowded trades, with a large number of investors holding similar positions in the options market.
  • The surge in demand for call options may drive up their prices, even if there isn't a corresponding increase in the stock's intrinsic value. 
  • If there is any adverse news or a change in market sentiment, the crowded nature of these trades could lead to a swift and exaggerated reaction in the options market. Traders may panic and rush to sell their call options, exacerbating market volatility.

Investors who follow the herd without a solid understanding of the risks involved may incur significant losses if the market sentiment suddenly turns negative.

How do mutual funds help avoid these biases?

You can avoid these biases (and a few more) if you follow the mutual fund route. Here is how:

Diversification: Mutual funds typically invest in a diversified portfolio of assets, spreading investments across various sectors and securities. It helps reduce the impact of poor performance in a specific stock or sector on the overall portfolio. By avoiding over-concentration in recent high-performing assets, mutual funds provide a more balanced and risk-managed approach.

Professional Management: Mutual funds are managed by experienced professionals who follow a predefined investment strategy and conduct thorough research. Fund managers are less likely to be swayed by short-term market trends or FOMO (herd mentality) as they are more focused on the long-term prospects of the underlying assets. Their disciplined approach helps counteract the influence of recent market movements on investment decisions.

Objective-based Investing: Mutual funds typically have specific investment objectives outlined in their prospectus. These objectives guide the fund manager's decision-making process, focusing on the fund's long-term goals rather than short-term market fluctuations. Investors can align their investment goals with the fund's objectives, helping to mitigate the impact of Recency Bias.

Regular Review and Rebalancing: Mutual funds often have a systematic approach to portfolio review and rebalancing. It involves periodically assessing the fund's asset allocation and making adjustments based on market conditions and the fund's objectives. The disciplined approach helps prevent the portfolio from being overly influenced by recent market movements or any kind of herd mentality.

Before you go

You can benefit from mutual funds by adopting a disciplined and diversified investment strategy, focusing on your long-term goals, and avoiding the pitfalls associated with bias like recency and herd mentality. It is crucial that you stay informed, conduct due diligence, and choose funds that align with your risk tolerance and investment objectives.

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