How do anchoring effects influence mutual fund selection?

Anchoring effect in behavioral finance refers to the tendency of investors to rely heavily on the first piece of information they see (the “anchor”) while making investment decisions. In mutual fund selection, investors often get influenced by an earlier NAV, past returns, or rankings, and make decisions that may not be in line with their actual financial goals.

1. What Is Anchoring in Mutual Fund Selection?

Anchoring is a psychological bias where investors place too much importance on one specific data point while choosing a mutual fund. This could be a previous high return, the initial NAV, or even a fund's name or past ranking. It often leads to ignoring other critical factors like risk, fund manager performance, or consistency.

Example:

If a mutual fund previously gave 25% returns in one year, many investors might consider it a good fund—even if it underperformed in subsequent years. That 25% return becomes their anchor.

2. How Anchoring Affects Mutual Fund Investment Decisions

Here’s how anchoring plays out in real investor behavior:

• Initial NAV Anchoring: Investors assume a lower NAV means a cheaper fund, ignoring the actual fund performance.
• Past Performance Anchoring: Many people stick to a fund that once performed well, even if it’s currently underperforming.
• Ranking Anchoring: Investors overly rely on "top 10" lists without understanding the methodology behind the rankings.
• Peer Comparison: If a friend made a profit in a certain fund, that becomes an anchor for decision-making without analyzing the fund objectively.

3. Why Anchoring Can Be Risky for Investors

Anchoring can mislead investors into making biased or poor decisions:

• They might invest in underperforming funds due to old data.
• It creates unrealistic expectations based on short-term performance.
• Investors may miss out on better funds with consistent long-term returns.

This psychological trap can prevent diversification and balanced decision-making, especially when financial goals and risk profiles are not aligned with the fund choice.

4. How to Overcome Anchoring Bias When Choosing Mutual Funds

Here are some practical steps to avoid falling into the anchoring trap:

• Evaluate Multiple Parameters: Look at consistency, volatility, portfolio quality, and fund manager experience.
• Use SIPs: Systematic Investment Plans reduce timing risk and help avoid decision-making based on short-term anchors.
• Set Investment Goals: Choose funds based on your long-term goals and risk tolerance, not just past numbers.
• Avoid Herd Mentality: Don’t get influenced by what others are doing or saying unless it aligns with your research.
• Review Regularly: Don’t hold a fund just because it performed well once. Reassess performance regularly.

5. What Tools Can Help You Avoid Anchoring?

Many investment platforms and advisors offer tools that help you assess funds objectively. For instance:

• Comparison dashboards that show multiple funds side-by-side
• Risk-adjusted return metrics like Sharpe Ratio or Alpha
• Ratings from CRISIL, Morningstar, etc., based on longer durations
• Portfolio insights to check asset quality and diversification

Angel One offers advanced tools to screen, compare, and analyze mutual funds, making it easier to avoid psychological biases while investing.

Anchoring is a common bias, but it can seriously impact your mutual fund portfolio if left unchecked. The key is to base decisions on thorough analysis, not isolated numbers or initial impressions. By using a goal-based and data-driven approach, investors can make smarter and more rational mutual fund choices. With platforms like Angel One, retail investors can access the right tools and insights to stay informed and avoid common psychological traps like anchoring.