Understanding investor sentiment: How can behavioural finance impact portfolio rebalancing?

Portfolio construction and management revolve around achieving the optimal risk-adjusted return. However, behavioural factors often influence investment decisions in ways that depart from conventional finance theory.

The study of behavioural finance integrates psychological and sociological factors to analyse how human emotions and biases can impact financial choices in ways that may deviate from rational decision-making. In this article, we explore the potential ways how behavioural finance impacts portfolio rebalancing decisions of mutual fund investors and ways to counter such biases.

• Table of contents

1. Cognitive biases in portfolio management
2. Impact of behavioural finance on in portfolio rebalancing
3. Strategies for behavioural investors
4. FAQs

Cognitive biases in portfolio management

• Anchoring bias refers to the human tendency to rely too heavily on information received early on when making subsequent judgments. In the context of mutual funds, this may lead investors to cling strongly to their original investments even if rational analysis suggests that it’s time to move away from them.
• The disposition effect is the tendency of investors to sell off profit-making assets too quickly while holding on to loss-making ones longer than they should. A related bias is loss aversion, which says that investors feel the pain of loss nearly twice as much as the pleasure of equivalent gains.
• Another common bias is herding, where investor behaviour is influenced heavily by peers and the crowd.
• Recency bias causes investors to give disproportionate importance to recent events when making decisions.
• The momentum effect leads to chasing past winners and shunning previous losers even as their roles reverse.
• Additionally, there is the hot hands fallacy, in which a person’s past successes are viewed as predictors of future outcomes, even when there may be no correlation between the two.
• These cognitive biases undermine the core principles of financial theory – buying assets when they have declined in price (value investing) and selling those that have risen substantially instead of chasing short-term momentum. In this manner, these biases directly impact rational portfolio rebalancing decisions.

Impact of Behavioral Finance on Portfolio Rebalancing

• Anchoring and disposition effect can lead investors to hold on to underperforming mutual funds for too long due to loss aversion or because of the initial promise they held. As a result, allocations can drift from targets and rebalancing is delayed unnecessarily.
• Herding behavior can result in panic selling or panic buying, which in turn can lead to market crashes or economic bubbles.
• Recency bias can lead investors to make decisions based on short-term trends rather than more reliable long-term performance. Loss aversion and momentum together ensure investors are slow to sell loss-making mutual funds but quick to exit current gainers.
• Ultimately, cognitive biases can hamper the investor’s choice of fund as well as decisions related to reviewing and rebalancing their portfolio. Instead of taking timely rebalancing and reallocation decisions based on performance alone, several biases come into play.

Strategies for Behavioral Investors

• Clearly define strategic asset allocation targets upfront for equity, debt, gold etc. based on risk profiles rather than reacting to markets.
• Commit to a disciplined, periodic review or rebalancing – such as annual or half-yearly – to avoid the temptation of following the herd during a brief spurt of activity in the market.
• Isolate each asset class and compare its performance to your target allocation objectively rather than focusing only on winners or favorites.
• If a fund is underperforming, carefully look at the reason it may be doing so rather than selling it off in a rush. Compare its performance relative to its benchmark and its peers. If the underperformance is a market-wide trend because of the current economic scenario, it may not signal trouble in the fund.
• Use automation wherever possible (if provided by fund houses) to rebalance with minimal manual intervention and emotion.
• Consult unbiased advisors during turbulent periods if susceptible to crowd behavior to aid calmer decision-making.
• Diversify across asset classes, sectors, and styles rather than chase the latest hot performer to mitigate the impact of momentum.

Conclusion
Incorporating perspectives from behavioral finance can give mutual fund investors a framework to overcome hardwired cognitive biases at the time of portfolio rebalancing. A disciplined, emotionally detached periodic review to realign allocations per predefined targets is crucial. While biases cannot be wished away, being aware of their impact and structuring decisions responsibly can facilitate wiser rebalancing decisions.

FAQs

How does investor sentiment affect portfolio rebalancing decisions?
If overall market sentiment is fearful after a crash, investors may delay rebalancing or exiting losing asset classes due to loss aversion bias. During periods of high optimism, fear of missing out can cause investors to stay invested in assets that are now overvalued or to neglect rebalancing the portfolio even if the allocation has veered away from the investor’s risk profile.

How does investor sentiment influence asset allocation decisions?

Investor sentiment refers to how optimistic or pessimistic investors feel about the market and economy. Positive sentiment makes investors more willing to take on risk, so they allocate more of their portfolio to assets like stocks. Negative sentiment has the opposite effect, as fearful investors want to reduce their risk exposure, leading to more allocation into relatively stable assets like bonds and cash.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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