Herd Mentality in Mutual Fund Management
Did you know?!
Herd Mentality is a phenomenon followed by a huge crowd, including investors and seasoned professionals, rather than relying on independent analysis.
It is one of the most fascinating psychological biases in the finance market. Investing might look like a numbers game based on market research, logic, and data. However, human psychology has a huge impact in shaping investment decisions.
What comes to your mind when you think about Mutual Fund Managers?!
Probably, the one who makes well-analyzed, rational decisions that help in fetching maximum returns for investors. Right?!
But the fact is that they themselves are non-immune from this biased psychology. The baggage of maintaining industrial credibility, performing well and standing out, compels veteran fund managers to follow the footsteps of their peers and group discussions.
But why does herd mentality exist among mutual fund professionals? What are its consequences? And what does it mean for investors who trust these managers with their money?
Why Do Fund Managers Follow the Herd?
A thought may cross your mind that despite being well equipped with research-related tools, market insights, and years of experience, what forces them to be a follower? Let’s see:
Career risk is a major reason. As mutual funds’ performance is analysed not just by investors but industry analysts and rating agencies play a crucial role. Thus, this makes mutual funds highly competitive. Manager who fails by independently conducting an investment approach, faces criticism, while if they go with the market trend and things don’t work out, collectively the industry is blamed.
Another key factor is benchmark-driven investing. As per the policy, market indicators like NIFTY 50 OR THE S&P 500 are used to compare mutual funds. Underperforming these indicators can lead to a poor rating and redemption from investors. To secure their results from falling far behind managers, copy these benchmarks, as a resul,t it reduces the outperforming potential due to identical mutual funds portfolios.
Last but not the least, Fear Of Missing Out, to prevent themselves from underperforming, fund managers hearing about a trending stock or sector rush to buy it. The 1990s technology stock boom is a perfect example, where investors blindly invested money into tech stocks without fully evaluating their fundamentals. When the bubble burst, many mutual funds suffered huge losses.
How Herd Mentality Impacts Mutual Fund Performance?
The effects of herd investing are far-reaching:
One of the most obvious consequences is overvaluation of stocks. Due to a huge amount invested in the same stocks, their price inflates, exceeding their actual value. This artificial inflation leads to re-evaluation, where prices drop drastically, affecting fund returns and, in turn, investor portfolios.
A well-structured mutual fund should have a diversified portfolio. Due to herd mentality, fund managers are compelled to invest their holdings in a handful of rising stocks, instead of investing in different asset classes and sectors. Therefore, it makes portfolios vulnerable to crashes.
On the other hand, underperformance is another big problem. The chances of outperforming and delivering maximum return are significantly reduced when all fund managers invest in the same assets. As a result, many mutual funds end up operating like closet index funds, offering no real advantage over passive investing strategies.
Another upcoming challenge in a row is Market volatility, which occurs when multiple fund managers enter and exit trades simultaneously. Market becomes unstable when a popular stock starts losing appeal and sudden sell-offs diminish its value.
Historical Examples of Herd Investing
Herd mentality has had its influence for years. Financial history has a few instances where fund managers’ behaviour and this psychology biases collectively led to market bubbles and crashes.
- In the year 2008, assuming the low-risk, many mutual funds were heavily invested in stocks backed with mortgage securities. After the collapse of the housing market, these funds faced huge losses.
- In 2022, a most recent incident happened post-pandemic where fund managers invested massive amounts in technology and pharmaceutical stocks. But when interest rates started rising in 2022, these same stocks faced a sharp correction, affecting several high-profile funds.
How Can Investors Protect Themselves?
In order to safeguard investments, fund managers need to be strategic and make wise decisions by being proactive and following the steps below:
1. Carefully analyze the Investment strategies of the fund manager. Check whether a fund manager independently strategies or follows the ongoing market trend. Funds with calculated risks and well-researched stock selection will give long-term results.
2. Be wiser with overhyped sectors, if a particular sector is getting too much attention, exercise caution. Diversification across various sectors can aid from market fluctuations and prevent overexposure to trending stocks.
3. Before you put money into a fund, review portfolio holdings and carefully study its main investments. When a fund’s holdings match a benchmark index, it might not be giving you true active management. Keep a track on funds that own unique stocks or sectors backed by reliable investment logic.
Is Herd Mentality Always a Bad Thing?
Well! Surprisingly not, herd mentality can lead to significant gains if the market identifies long-term trends accurately.
Whether the herd is following fundamentals or speculation is the key difference. If the investments have long-term growth potential and are backed by reliable and solid research, following the trend will lead to gain. However, when driven by fear, greed, or speculation, it often leads to losses.
Also, check – Is a Cheaper Mutual Fund Always Better?
Final Thoughts
Herd mentality is like a strong tide, you can try to resist, but it’s tough not to get carried along. Despite the expertise, mutual fund managers go with the flow of market trends, peer pressure and industry norms. This behaviour might seem secure, but it carries occasional financial crises, decreased diversification along.
The only wiser way for investors is to be aware of these behavioral patterns and make sure to do diligent research before investing. Prefer logic and diversification rather than blindly following the ongoing market trends.
In the end, following the crowd will not guarantee success but making informed and independent choices that align with financial goals does.
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Why do fund managers follow the crowd?
For performing well and avoiding criticism, even experienced fund managers do the same. The thought behind it is, if they follow what everyone else is doing and fail, they don’t stand out as the only ones who made a mistake.
How does herd mentality affect mutual funds?
When too much is invested in the same stock by fund managers, the price rises too much, which makes it risky. It often leads to big losses during market crashes. Also, it reduces the variety of investments.
Is following the herd always bad?
It is not always wrong to follow the herd. If the analysis is strong enough and free of fear, it can fetch good returns.
How can investors avoid herd-driven funds?
Avoid putting too much money in high-performing stocks and make sure your investments are spread across different sectors. Moreover, wisely hire a fund manager who has sound experience and not a follower of trends only.
Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before making an investment.
