Behavioral Biases in Finance That Affect Investing Decisions
Investing isn't just about numbers; it's deeply intertwined with human psychology. Bias in investing plays a crucial role in decision-making, and can significantly impact financial outcomes.
These behavioural biases in investing often cause investors to deviate from rational decision-making. Hence, understanding these biases in behavioural finance is essential for making informed investment choices.
Behavioural Biases Meaning
Behavioural biases are ingrained mental shortcuts that influence how we perceive and react to information. Instead of making rational decisions based on data and insights, investors may unknowingly fall into psychological traps that many times lead to errors in judgment. These behavioural biases can cause impulsive reactions to market volatility, excessive risk-taking, or missed investment opportunities.
Common Biases in Investing
In this series of blogs, we delve into three common behavioural biases in investment decision making that often trip up investors.
1. Hot Hand Fallacy
One of the most common behavioral finance biases is the hot hand fallacy, which is the belief that past success in a random event increases the likelihood of continued success. This bias in finance often leads investors to assume that assets or funds that have recently performed well will continue to do so.
For instance, during FY 2023-24, there was a significant inflow into small and mid-cap funds, driven by optimism that their past outperformance would persist. However, history shows that periods of stellar returns are often followed by low or negative performance. A well-documented hot hand fallacy example is when small and mid-caps outperformed in 2012 but lagged in 2013, and after strong gains in 2017, they underperformed in 2018 and 2019.
Source: AMFI and CMIE. Data for the Period of FY 23-24. Mutual Fund Net Flows (In ₹ crores) are total category net flows in the Large Cap Mutual Funds, Mid Cap Mutual Funds and Small Cap Mutual Funds. The Absolute Return (%) is for the Nifty 100 Total Return Index, Nifty Mid Cap 150 Total Return Index and Nifty Small Cap 250 Total Return Index for Large Cap, Mid Cap and Small Cap respectively. Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.
Takeaway: Avoid chasing past performance. Focus on the underlying fundamentals and long-term potential of investments.
2. Naive Diversification
Another prevalent bias in investing is naive diversification, where investors spread their money across multiple options without considering their merits, overlap or correlations. While diversification is a fundamental principle of risk management, blindly spreading investments without a strategy can lead to inefficiencies.
Source: ICRA. Data for the period of 2010 to 2024. Equity 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. The "5 Least Correlated Schemes" Portfolio is created by selecting one scheme each from five different groups, based on their average correlation with other schemes over the past 6 years (using daily returns). The "15 Best Performing Schemes" Portfolio comprises the top-performing schemes from each of the eight categories, selected based on their 1-year past performance. The "Random 15 Schemes" Portfolio represents the average performance of 15 randomly selected portfolios, each consisting of 15 schemes picked randomly across the eight categories. Annualised Return, Volatility are averaged across these portfolios. Each year starting from 2010, these portfolios are created up to 2014 and their performance and volatility is compared for the next 10 year period. Annualised Return and Volatility calculated as the median values across five different 10-year periods (i.e. 2010 to 2020, 2011 to 2021, 2012 to 2022, 2013 to 2023, 2014 to 2024). The Reward-to-Risk Ratio is calculated as the ratio of Annualised Return to Volatility. Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.
For example, the data above illustrates how a well-constructed portfolio of five least-correlated schemes delivered a median 10-year return of 16.69%, outperforming both a randomly selected 15-scheme portfolio (14.53%) and a top-performing 15-scheme portfolio (15.40%). This underscores the drawbacks of Naive Diversification.
Takeaway: Diversify with intention. Analyse and select schemes with low overlap or distinct characteristics to build a diversified and resilient portfolio.
3. Recency Bias
Recency bias is a cognitive tendency where individuals place greater emphasis on recent events while overlooking long-term trends. In investing, this bias can lead investors to make decisions based on the latest market movements rather than considering historical data and broader market patterns. As a result, they may overreact to short-term fluctuations, potentially compromising long-term investment strategies.
Source: ICRA. Data for the period of January 2000 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 2000-2024. “Top” refers to the schemes in top 2 Deciles and “Bottom” refers to the schemes in bottom 2 Deciles 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 underscores the uncertainty of relying on past performance for future success. More than 70% of mutual fund schemes that ranked among the top 20% last year failed to maintain their position in the following year. Interestingly, nearly 67% of the worst-performing schemes in the current year showed notable improvement compared to the worst performers of the subsequent year.
Takeaway: Maintain a long-term perspective. Don't let short-term market fluctuations derail your investment strategy.
Conclusion
Being aware of these behavioural biases in investing is the first step towards mitigating their impact on your investment decisions. By adopting a rule-based, disciplined and quality focused approach, investors can navigate these biases in behavioural finance effectively.
The NJ Mutual Fund Investment Calendar 2025 addresses key behaviour biases in investing and their impact in the real financial world. By using the calendar as a guide, investors can mitigate the impact of biases in behavioural finance and build a more resilient investment strategy that stands the test of time.
FAQs
1) What are biases in finance?
Behavioral biases in investing are mental shortcuts or psychological tendencies that cause investors to make irrational financial decisions. These biases lead to impulsive reactions, excessive risk-taking, or missed opportunities, impacting long-term investment performance.
2) What is bias and its types?
Bias is a tendency to think or act in a particular way that deviates from rational judgment. In finance, several types of biases influence investor decisions, such as the hot hand fallacy, naive diversification, recency bias, status quo bias, among others.
3) How biases affect investor behaviour?
Biases significantly impact investor behavior by influencing decision-making in unpredictable ways. Rather than focusing on rational understanding, investors may be swayed away through emotions.
Investors are requested to take advice from their financial/ tax advisor before making an investment decision.
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
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