How to avoid behavioural biases while investing in Mutual Funds
Summary
This article explains how common behavioural biases, like overconfidence, herd mentality, loss aversion, recency bias, and anchoring, can derail mutual fund investing. By recognising these emotional traps and focusing on data, long-term strategy, diversification, disciplined reviews, and the right guidance of mutual fund distributor investors can make calmer, wiser decisions that align with their true financial objectives.
Introduction
As humans, we think that our decisions are guided by careful reasoning and logic. But in reality, our tiny decisions of life are shaped by emotions, our hopes, fears, excitements, and instincts. They influence our choices before we even realise it. As Benjamin Graham once said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
This is where the behavioural gap comes into play. In investing, a sudden fear of loss can lead to selling too soon, while excitement over rising markets can tempt us to take some unnecessary risks. These subtle influences are known as behavioural biases, mental shortcuts that can impact our investing behaviour, leading us away from a rational, long-term vision. The first step toward controlling emotions is recognising them and making choices that are calmer, wiser, and better aligned with the true financial purpose.
What Are Behavioural Biases in Investing?
More than most people realise, behavioural biases are patterns that can cause investors to make decisions about investments that aren't purely rational. Instead of solely sticking to cold and hard facts, people may act on emotions, personal beliefs, or social pressures. The result of these biases can lead to impulse, misreading market signals, or overlooking solid strategies, whether we’re dealing with stocks or mutual funds.
These emotional bias traps are not just for new investors, even experienced investors can get caught. Especially during periods of extreme market movement, these biases can drive decisions that hurt portfolio performance, like it’s easy to sell when prices are low, buy when they’re sky-high, or sit on the sidelines and miss a great opportunity.
The chart below, “Vicious Cycle of Fear, Greed, and Hope” (Source: Raymond James), shows how emotions can impact investment decisions throughout market cycles.
At peaks, optimism can turn to euphoria, blinding investors to risk. At lows, despair and panic can push them to exit just when opportunities are strongest. Recognising these patterns is key to breaking the cycle and making investment decisions based on strategy, not emotions.
Let’s explore how emotions shape our investing behaviour, and the practical ways to avoid common behavioural biases for better mutual fund and market outcomes.
Breaking Free from Common Behavioural Biases in Investing
1. Overconfidence Bias
Overconfidence makes investors believe they can always “time the market” or pick only the top-performing funds.
Example: An investor decides to stop their SIPs, assuming that they will re-enter at “the perfect time” later. But in reality, they often miss the market’s upward movements during this break, thereby losing out on the power of compounding.
How to avoid it: Stay disciplined with systematic, rule-based investing such as SIPs. Rely on guidance of a mutual fund distributor and long-term strategy instead of instincts or guesswork.
2. Herd Mentality
Herd mentality occurs when investors follow the crowd instead of evaluating what’s right for them.
Example: When any schemes of Mutual funds become popular, many investors pour money into them without considering their own risk tolerance. When volatility hits they panic and redeem at a loss.
How to avoid it: Always select mutual fund schemes based on your personal risk profile and financial needs, rather than chasing trends or popular choices.
3. Loss Aversion
Loss aversion is when the fear of losing money feels stronger than the satisfaction of making a profit.
Example: An investor continues to hold an underperforming fund just to avoid “booking a loss.” In doing so, they miss the chance to move into a better-performing equity fund that could actually help them build wealth in the long run.
How to avoid it: Review your portfolio regularly and make decisions based on facts, not emotions. If a switch or exit is the smarter choice, don’t hesitate—let performance and suitability guide you, not fear.
4. Recency Bias
Recency bias makes investors assume that whatever performed well recently will keep performing the same way in the future.
Example: An equity mutual fund scheme gave poor returns in the last 6 months, so an investor stops his SIP, even though the fund has delivered steady long-term returns over 5+ years.
How to avoid it: Focus on long-term performance trends (5–10 years) and the overall quality of the fund. Don’t let short-term highs or lows cloud your judgment.
Let's understand this behavioural bias through a table:
Source: ICRA. Data for the period of January 2004 to November 2024. All the schemes from the “Flexi Cap Fund,” “ELSS,” “Large & Mid Cap Fund,” “Large Cap Fund,” “Mid Cap Fund,” “Small Cap Fund,” “Focused Fund,” “Multi Cap Fund” categories are considered. Based on their respective calendar year returns and 10 year CAGR, all the schemes are divided into deciles for each year in the period 2004–2024. “Top” refers to the schemes in top 2 Decile ranks; “Bottom” refers to the schemes in bottom 2 Decile ranks based on the performance. Average % of Schemes that changed in the top/bottom on a calendar year return basis represents the average percentage of schemes that were in the top/bottom decile in a given year but moved out of those deciles in the following year, based on that calendar year’s return. Average % of Schemes that changed in the top/bottom on a 10 year CAGR basis represents the average percentage of schemes that were in the top/bottom decile in a given year but shifted out of those deciles when evaluated on the next 10 year CAGR basis. Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.
This data shows that relying only on recent short-term performance to choose mutual funds can be misleading. In fact, over 71% of funds that were top performers in one year failed to stay at the top the very next year, and about 66% of the worst performers improved in the following year. Even over a 10-year period, performance rankings keep changing — the “stars” don’t always shine forever, and the “laggards” don’t always stay behind. History also reveals that more than 70% of mutual fund schemes ranked in the top 20% based on last year’s returns dropped out of that group the next year. This means chasing so-called “star performers” can be a self-defeating strategy. Instead of getting swayed by short-term highs or lows, it’s wiser to focus on long-term consistency, quality of the fund, and how it fits your investment plan.
5. Anchoring Bias
Anchoring bias happens when investors rely too much on old information or past numbers while making today’s decisions.
Example: An investor started investing in a mutual fund when it was giving 20% annual returns. Even though the fund’s performance has now dropped to just 6–7% over the past few years, the investor continues holding it because he is anchored to that “20% return expectation,” instead of re-evaluating whether the fund still deserves a place in his portfolio.
How to avoid it: Stay flexible and focus on the current facts. Review each scheme objectively, and don’t let old figures or outdated beliefs hold back smart decisions.
Conclusion
In the end, recognising and avoiding behavioural biases is essential for making smarter and more rational decisions. Emotions like fear, greed, and overconfidence can easily cloud judgment, leading to rushed moves, missed opportunities, or unnecessary risks. By being aware of behavioural traps, investors can take steps to base their choices on facts, analysis, and long-term strategy rather than short-term emotions or market noise. A disciplined approach, backed by regular portfolio reviews, diversification, and credible guidance, not only protects you from impulsive mistakes but also keeps you focused on your true financial objectives. In investing, patience and objectivity are often your greatest allies.
FAQs:
1) What are behavioural biases in investing?
Behavioural biases are mental shortcuts that cause investors to make irrational decisions based on emotions, personal beliefs, or social pressures, rather than on cold, hard facts. They can lead to impulse buys, selling too soon, or missing out on opportunities.
2) What's the best way to avoid these biases?
The best way to avoid these biases is to have a disciplined, long-term approach to investing. Focus on your personal financial goals and risk tolerance, not on short-term market noise or emotions. Regularly review your portfolio based on facts and performance, diversify your investments, and seek guidance from a Mutual Fund Distributor.
3) How can I avoid herd mentality when investing in mutual funds?
To avoid herd mentality, you should choose mutual funds based on your personal risk profile and financial needs, not because they are popular or trending. When a fund is overhyped, it's easy to pour money it without a second thought, but this can lead to panic selling and losses when volatility hits.