5 biases you may avoid while picking a mutual fund
What would you say are the chief causes behind underperforming Mutual Funds? Market instability, regulatory reforms etc.? What if I say you could be a reason behind it too? I’m talking about what experts call behavioural finance. It’s a concoction of all your emotions, thoughts and prejudices that influence your decision making. It can make you think in unusual ways and take financial decisions that you generally wouldn’t.
So, before you can overcome them let’s understand 5 of the most common biases.
- Herd mentality: It’s the tendency to move with a larger group. The moment we notice people are investing in a particular fund, we all start investing there thinking it’s the safer bet. The same happens when a few people exit a fund and others follow suit. Unfortunately, even if that trend was the right one for the time, by the time most people hear about it, it’s over. So, what you need to do is to recognise your goals, stick to your plan, and do your own research or consult a financial advisor rather than just following others blindly.
- Recency bias: We often think that a recent event or trend will continue forever. But no matter how impactful an event may seem, it would end at some point, and basing your investment on that is called recency bias. Every sector in market sees boom and bust where a trend skyrockets and then plummets to ground and thus you should never try to predict future solely based on these events.
- Focalism: Raise your hand if you often stick to the first piece of information you find. You’re not alone here. This is called focalism or anchoring bias where the first information itself makes your decision and what comes later hardly makes any difference. You shouldn’t hurry into any decision and should properly analyse all the information you have without any biases.
- Choice paralysis: This is something we all understand very well – it’s the inability to pick what you want to eat when you see an extensive menu. Or in this case inability to choose which fund to invest in when there are hundreds of them. This often keeps you from invest altogether or leads to randomly picking any fund. What you should rather do is to think about your goals, research on which fund can get you closest to that and then narrow down to fewer options. You can also consult your financial advisor.
- Confirmation bias: Does it ever happen that you already know which shirt you want and you still keep asking your friends till one of them picks the same one? That’s an example of confirmation bias where you only consider the data that confirms what you’re already thinking. You do this with mutual funds too and it might seem you did your research before investing but you only paid attention to the facts that went along with your thoughts. You can overcome this by considering the facts and data with an empty mind and by bringing in another person for a second opinion.
It’s true that our brain can be our worst enemy. We all are prone to having our way of thinking sabotage our plans and portfolios, but recognising these behavioural biases and working on it can be a good start to overcoming them.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.