That thing called investment regret

John Rekenthaler - VP, Research - Morningstar, talks about how regret can stop you from being a smart investor.
By Morningstar Analysts |  26-07-18 | 
 

Have you ever invested via time travel? Calculated how much money you would possess had you known the financial future? I confess to such daydreams.

1975

It is February and my parents inquire what I wish for my birthday, and I respond, “As much Berkshire Hathaway stock as you can buy for $1,000, please.”

(That would have been $985 more than the actual value of my birthday present, but never mind that detail.)

That transaction would have netted 25 shares. With Berkshire Hathaway shares now trading at $300,000, that 14th birthday gift would be worth a cool $7.5 million. Thanks, parents!

If that daydream proved real, nothing so far in my life would have changed. To be sure, that Berkshire stock would look splendid in my retirement account, but that’s where it would reside.

1989

This is when I proposed marriage. Rather than borrow from my boss to buy a small engagement ring, as actually occurred, I could have purchased a big ring by selling one Berkshire share. But who could make such a trade, knowing that would be $300,000 of future money? Not I.

Regret would have protected my shares. Whether that would have been an entirely good thing is debatable. Aesop preferred winter’s ants, but there is much to be said for the summer joys of the grasshopper. However, such thoughts lie outside the scope of this column. It concerns investments—and for those, regret would unequivocally been a benefit.

Of course, daydreams being just that, we cannot perceive what is to come. We do not experience that version of regret. What we encounter instead is unhappiness about what might have been—the regret that arises from lamenting the past. That emotion, too, can be helpful.

Two views on Target Dates

To understand how regret informs our real-life investments, consider target-date funds. Nine years ago, nobody criticized such funds for being too conservative. Nobody said such a thing, at least publicly. Most target-date funds had suffered heavily during the 2008 financial crisis, leading to criticism that, as a breed, they held too many equities. The Senate convened a subcommittee to determine whether target-date investment policies should be more tightly regulated. (It decided not.)

In contrast, a current article on a site called Mathematical Investor, by “Mathematicians Against Fraudulent Financial and Investment Advice,” frets that target-date funds are overcautious. “Given [rising] life expectancy projections, we need to ask whether most target-date strategies, typically an equity/bond mix varying from 80/20 at the start to 40/60, 30/70 or even 20/80 at the target retirement date, really make sense in today’s world. Aren’t these figures, which are so commonly used in the investment world, a bit out of date?"

The authors continue, “Perhaps investors should be advised to remain in a mostly equity portfolio longer into their careers and, depending on circumstances, perhaps even after retirement.”

That is a reasonable perspective, as were the 2009 suggestions that target-date funds approaching maturity should reduce their stock positions, to ease the volatility for new retirees who roll over their 401(k) funds. Both beliefs have their merits. Target-date funds come off the rack; the outfit that is too long for this investor, will be too short for that one. No target-date family’s asset allocation can be ideal for all shareholders.

Emotional drives

However, one side of the argument could only be published now, and the flip side only then. (That is not strictly true. Counter-cycle articles can indeed be published at any time—but they will be ignored.) The reason is regret. It motivates the reader. Remorse about being reckless entering the 2008 financial crisis sold 2009’s bearish admonishments, and remorse for money left on the table propels 2018’s bullish thoughts.

(This process, albeit gradually, has a ripple effect on the investment policies of target-date funds. Although portfolio managers strive for independence, so that they are not swayed by investor demand, the truth is that shareholder preferences do affect target-date funds’ tactics. Inevitably, the funds’ asset allocations drift toward what the market desires.)

This process, clearly, can be harmful. Regret about relinquishing future gains, as with my time-travel daydream, unquestionably improves investment results. Regret about the past is less helpful. Regret encourages investors to seek that which is currently fashionable, and to avoid that which is not. Blindly obeying its urges is a prescription for buying high and selling low. That is no way to live.

With regret

However, there is a way to use the desire constructively. That involves accepting the emotion, rather than rejecting it.

What I mean, specifically, is that every portfolio should contain unpleasant investments—securities that would have been uninspiring choices during the past few years, if not outright poor. Fleeing from regret involves jettisoning such holdings. The classic example consists of selling stock funds in 2009, and replacing them with bonds, alternatives, or tactical-allocation funds. Such decisions did not fare well.

Embracing regret, on the other hand, means swapping popular securities for unpopular. Perhaps such trades will not take place. The investor who conducts a regret test, to see which portfolio holdings make her wince, may decide that she already has enough problems. But, perhaps, the portfolio should be changed. It looks lovely in hindsight—but is dangerous with foresight, because it leans heavily on a handful of the hottest asset classes.

This suggestion hits home. Currently, my portfolio contains only assets that provide no regret: U.S. equities that have increased in price, and the funds that own such securities. That feels great. Some days, the portfolio even convinces me that I am smart. That belief is rash. My portfolio needs an overhaul.

Easier to write than to do! It is easy to cast aside investments that have caused pain, but difficult to scrap those that have provided pleasure. This column, I suppose, can be regarded as a self-motivational speech—the attempt to convince myself to do what I should. It is, however, equally good advice for all.

Add a Comment
Please login or register to post a comment.
<>
Top
Mutual Fund Tools
Feedback