How Recency Bias Can Impact Mutual Fund Investment Decisions

Mutual fund investing, especially in equity avenues, is a long game. However, humans tend to be swayed by the desire to make immediate gains or offset losses in the near term.

The impact of emotions and other psychological factors on investment decisions is the focus of behavioural finance. This area of study combines insights from psychology, sociology, and economics to understand the emotions, biases and cognitive patterns that drive financial decisions and how these affect market outcomes.

One such behavioural bias is recency bias. This is the tendency to give undue importance to recent events or experiences when making decisions, often at the expense of historical data or long-term trends. This article explores recency bias in detail and looks at its impact on how investors evaluate the performance of their mutual fund investments.

Table of contents

What is recency bias?
How recency bias affects mutual fund evaluation
How to overcome recency bias

What is recency bias?

Recency bias is the tendency to place greater emphasis on recent events or performance over historical data when making a decision. It stems from the natural tendency to remember recent events with greater clarity and detail than older ones.

In the context of mutual fund investing, recency bias can cause investors to give greater emphasis to short-term performance instead of long-term trends when evaluating the performance of a mutual fund scheme. This can cause them to invest or exit a scheme based only on the latest quarter’s results, ignoring the scheme’s track record or wider market trends.

How recency bias affects mutual fund evaluation

Let’s take a detailed look at how recency bias can affect an investors’ evaluation of a mutual fund scheme.

Overemphasis on short-term performance: Investors influenced by recency bias often place too much importance on a fund's short-term returns. A mutual fund that has performed well in the last few months might attract more investors, even if its long-term performance is mediocre or volatile.

Neglecting long-term trends: A fund’s performance over multiple market cycles gives a better picture of its strategy and robustness. However, recency bias leads investors to overlook this crucial aspect. A fund with a history of strong, consistent returns might be ignored if it has a few bad months.

Increased volatility in investment decisions: Investors swayed by recency bias may make more frequent trades, switching in and out of funds based on recent performance. This behaviour can increase transaction costs and reduce overall returns.

Misjudging fund manager’s skills: A fund manager's true skill is best evaluated over a long period. Recency bias can cause investors to misjudge a manager's abilities based on recent performance, which might be due to market conditions rather than skill. Or, the fund manager may have deployed a long-term strategy that may not show immediate results.

Herding behaviour: If recency bias influences the decisions of multiple investors, it may result in herding behaviour, which is the tendency to follow the crowd instead of making carefully considered independent decisions. For instance, during a bull market, funds that have recently outperformed tend to attract massive inflows. Conversely, during a market downturn, funds that have underperformed might see significant outflows, regardless of their long-term potential.

How to overcome recency bias

Focus on long-term performance: When evaluating mutual funds, prioritize long-term performance metrics over short-term gains. Look at the fund's performance over several years, including different market cycles. This is especially important if you have a long investment horizon.

Diversification: Diversifying your investment portfolio can help mitigate the effects of recency bias. By spreading investments across various asset classes and funds, you reduce the risk of being overly influenced by the recent performance of a single fund.

Lay out your goals and financial plan: Clearly define your investment plan and strategy and evaluate whether a fund aligns with your long-term investment goals before making buy or sell decisions. Having clear goals can help you stay focused and resist the temptation to chase short-term performance. Align your mutual fund choices with your overall financial objectives rather than recent trends.

Seek professional advice: Consider seeking advice from financial professionals who can provide a more objective assessment of mutual fund performance. They can help you avoid common biases and make more informed decisions.

Conclusion

Recency bias is a common psychological pitfall that can significantly impact mutual fund performance evaluation. By recognising and addressing this bias, investors can make more rational, informed decisions. Focusing on long-term performance, diversifying investments, conducting regular portfolio reviews, seeking professional advice, and setting clear investment goals can help mitigate the effects of recency bias. This can help investors work towards their financial objectives keeping the larger picture in mind rather than making emotional decisions based on short-term market movements.

FAQs

What is recency bias and ow does it affect mutual fund evaluation?

Recency bias is the tendency to give greater importance to recent information or developments over long-term trends when making a decision. It can affect how investors evaluate the performance of a mutual fund scheme if they overemphasize short-term gains and overlook long-term performance.

How can I avoid recency bias when choosing mutual funds?

To avoid recency bias, compare a scheme’s performance over multiple time horizons and market cycles. Also, diversify your portfolio to spread investment risk over multiple avenues, set clear investment goals and measure every financial decision against those. Also, seek professional advice whenever possible, especially for major investment decisions.

Why is long-term performance more important than short-term gains in mutual fund evaluation?

Long-term performance provides a more accurate picture of a fund’s potential, reflecting its ability to perform consistently across different market conditions, whereas short-term gains can be influenced by temporary factors such as short-term trends or brief outperformance of a particular stock/market segment in a portfolio.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

Points To Consider?