Understanding herd mentality and how it can influence mutual fund investments

Choosing the right mutual funds can often feel challenging, especially if you’re new to investing. Without accurate financial guidance, you may thus feel tempted to invest in a particular scheme or mutual fund category just because everyone else seems to be doing so. This tendency is known as herd mentality.

Herd mentality can significantly impact your investment decisions, leading you to invest in funds or stocks that may not align with your investment objectives.

This article tells you more about herd mentality and how you can counter it to make smarter investment decisions that can potentially lead to long-term investment growth.

• Table of contents

1. What is herd mentality?
2. How herd mentality can influence mutual fund investments
3. Advantages of making informed investment decisions
4. How to avoid herd mentality and chart your own investment path
5. Importance of behavioural finance

What is herd mentality?

Herd mentality refers to the tendency to follow the actions of a larger group, even if they go against one’s beliefs or better judgement. This behaviour is driven by the fear of missing out or the belief that if many others are doing something, it must be right.

For example, if you hear that a particular mutual fund or market sector is performing well and notice that many people around you are investing in it, you might feel inclined to invest in it, too, without doing independent research. This is a classic example of herd mentality in investing.

Herd mentality is one of many cognitive biases studied by behavioural finance, a field of study that looks at how human emotion and psychology influences financial decisions. Behavioural finance recognises that investors aren't always rational, often making choices based on emotions and biases rather than logic.

How herd mentality can influence mutual fund investments

Herd mentality can have a significant impact on your mutual fund investments, often leading to decisions that may not be in your best financial interest. Here’s how:

1. Misaligned investments: Following the crowd may lead you to invest in a fund that is currently popular but may not be aligned with your risk appetite, investment objectives or long-term goals. For instance, if the small cap segment is doing exceedingly well, many investors may opt for a particular small cap fund, not taking into account the fact that this segment is highly volatile and only suitable for those with a high risk appetite and a long investment horizon.

2. Missed opportunities: Herd mentality can cause you to overlook other potentially profitable investments. By focusing only on what everyone else is doing, you may miss out on mutual funds that are less popular but have strong growth potential.

3. Emotional investing: When you invest based on emotions rather than logic, you are more likely to make poor decisions. Herd mentality often causes people to buy high (when everyone else is buying) and sell low (when everyone else is selling). This is the opposite of traditional investment advice, which is to buy low and sell high.

Advantages of making informed investment decisions

Instead of following the crowd, making informed investment decisions can lead to better financial outcomes. Here are some advantages:

• Power of compounding: When you invest wisely and give your investments time to grow, you benefit from compounding. Compounding means that the returns you earn on your investments start earning their own returns, creating a snowball effect that significantly boosts your wealth-building potential over time.
• Accelerated compounding with time: The longer you stay invested, the more your money grows. Even small investments can turn into large sums if given enough time. This is because the pace of compounding typically accelerates with time, potentially leading to exponential growth over the long term.
• Greater control over your financial future: By making informed decisions, you take control of your financial journey. You can tailor your investments to suit your specific goals, risk tolerance, and time horizon rather than being swayed by market trends or the actions of others.
• Reduced risk of losses: Informed decisions are often based on thorough research and understanding, which can help you avoid high-risk investments that may not align with your financial goals. This reduces the likelihood of suffering significant losses due to market volatility or poor investment choices.
• Opportunities for better returns: By staying informed and not following the crowd, you might discover investment opportunities that others overlook. For instance, you may identify a mutual fund category or a stock that may not attract short-term buzz but has strong long-term growth potential because of strong fundamentals or a forward-looking and robust investment strategy.

How to avoid herd mentality and chart your own investment path

Avoiding herd mentality and creating your own investment strategy is crucial for long-term success. Here are some steps you can take:

• Do your own research: Before investing in any mutual fund, take the time to research its performance, the fund manager’s track record, and the fund's objectives. Don’t just rely on what others are doing—make sure the investment aligns with your financial goals.
• Start early: As they say, the best time to start investing was yesterday. But the next best time is now. Starting early allows you to take advantage of compounding and can make it easier to reach your financial goals. Even if you start with a small amount, such as Rs 500 a month, it can grow into a significant amount by the time you retire.
• Stay focused on your goals: Everyone has different financial goals, risk tolerance, and timelines. What works for someone else may not work for you. Focus on your personal goals and create an investment plan that suits your needs.
• Diversify your investments: Diversification is key to reducing risk. Instead of putting all your money into one popular fund, spread your investments across different asset classes and sectors. This helps mitigate impact on your portfolio from market fluctuations.
• Be patient and disciplined: Patience and discipline sets the foundation for successful investing. Stick to your investment plan and avoid the temptation to make impulsive decisions based on market trends or what others are doing. Remember, investing is a long-term journey.
• Seek professional advice: If you’re unsure about where to start, consider seeking advice from a financial advisor. They can help you create a personalised investment plan and make informed decisions.

Importance of behavioural finance

At Bajaj Finserv AMC, behavioural finance is a core tenet of the investment philosophy driving all mutual fund schemes. Bajaj Finserv AMC follows its in-house investment philosophy, InQuBe, which comprises three elements – Information edge, Quantitative Edge and Behavioural edge. While the first two edges focus on getting superior market information and processing it faster, the third edge focuses on behavioural finance. Through this, fund managers seek to tap into market inefficiencies based on behavioural finance insights and be mindful of their own cognitive biases when making investment decisions.

Conclusion

While it's natural to feel the pull of herd mentality, especially when it seems like everyone around you is making the same investment decisions, it's crucial to take a step back and think critically about your choices. Making informed decisions, rather than following the crowd, can lead to better financial outcomes in the long run. By understanding the risks of herd mentality and taking advantage of strategies like the power of compounding, starting early, and opting for a step-up SIP, you can build a strong financial future.

FAQs

What is herd mentality in investing?

Herd mentality in investing refers to the tendency to follow what others are doing, often leading to decisions that aren't based on personal research or understanding.

How does herd mentality affect my investments?

Herd mentality can lead to overvalued investments, lack of diversification, missed opportunities, and emotional investing, all of which can negatively impact your returns.

Why is it important to start investing early?

Starting early gives your investments more time to grow through the power of compounding, helping you build a larger corpus over time.

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.