We often feel regret when we can clearly envision the alternative paths we didn’t take and decide those paths would have been better than the one we ultimately chose.
It’s particularly easy to see the alternatives after the fact when you are an investor. Winning investments always find their way to the center of attention of financial media, social media, and social interactions.
Investing is also highly quantifiable, which can lead us to believe there’s always an objectively optimal decision out there. Knowing that there’s an optimal choice as well as the opportunity for things to go wrong leads many investors to put a lot of pressure on themselves.
In this episode, Peter explains where regret comes from, why we experience it with our portfolio, and what to do about it.
Listen now and learn:
- Strategies to minimize regret in advance
- Common situations where feeling of regret are most likely to impact our investment decisions
- When a bad outcome is and isn’t the result of a poor decision
Plus, Peter answers a listener question about whether the stock market is in a bubble.
Think about the major choices you’ve made in your life.
- Picking a career path,
- choosing a life partner,
- deciding to have children,
- changing jobs….these are high-stake decisions because each forces you to set aside all possible futures except the one you ultimately choose.
Any potential future is completely unknowable in the present moment.
- But the act of choosing something, even if we don’t know whether it’s right or wrong, optimal or less so, gives us a sense of control and responsibility over our decision.
When the outcomes eventually reveal themselves, it’s easy to feel regret when they aren’t what we hoped or expected. And regret is painful – literally.
When I experience regret, it’s not just in my head. It feels like my heart swells up and makes it harder to breathe. It’s not pleasant, and it’s something I obviously prefer to avoid.
While I (unfortunately) don’t have the answers for minimizing regret you could feel about big life choices, I do have some wisdom to offer for investing.
To start, it helps to understand where regret often comes from and why we experience it.
- We often feel regret when we can clearly envision the alternative paths we didn’t take and decide those paths would have been better than the one we ultimately chose.
This is largely an illusion, of course; there is no perfect portfolio because we can’t know in advance what strategies or asset classes will win over any given time period.
- If we kick ourselves for missing an obvious opportunity, it’s probably because we conveniently forgot it was only “obvious” after the fact.
This sort of hindsight bias is a normal working part of human memory, but it’s a feature that often causes a lot of unnecessary grief in the investment experience and can intensify feelings of regret.
How to Minimize Regret with Your Investment Decisions
In order to minimize regret about your investments, it’s useful to think about how you might feel in the future about the choices you make today with your portfolio.
Ask yourself, “In ten years, what would make me regret this decision? What are some ways this decision could lead to bad outcomes, and how would I feel in these scenarios?”
It’s also helpful to think deeply about whether you are more concerned about implementing a bad idea or missing out on a good one.
When the FDA evaluates a new drug, for example, they seek to minimize the chance of approving a drug that is not beneficial to people’s health or that causes bad side effects. In doing so, they simultaneously increase the probability of failing to approve a drug that would improve people’s health.
It’s a choice between making a Type I error and a Type II error.
- Minimizing one leads to a higher chance of realizing the other.
- The FDA must manage this tradeoff when approving safe drugs for the public, and investors must do it when determining the best strategy to use for their situation.
As you think about what would cause more pain – making a bad investment or missing a good one – you must remember that bad outcomes are not always the result of a bad decision; sometimes you simply get unlucky or the probabilities don’t work out in your favor.
That’s why no investment action should be taken unless it is adequately supported by good evidence, which also requires that you have a good process for interpreting the evidence you have.
Evidence-Based Decision-Making Processes Can Help Reduce Regret
Let’s look at a specific example to see how you might use an evidence-based approach to evaluate an investment decision in the context of minimizing regret: the choice to own International stocks.
The case for owning international stocks centers on diversification – it’s less about directly increasing return and more about reducing risk, which ideally improves the amount of return you earn for the degree of volatility you assume.
- This is what asset allocators refer to as improving risk-adjusted return.
All else being equal, when comparing two portfolios with the same average annual return, the one with lower volatility will have higher compounded returns over time because compound interest works better with lower volatility returns.
- By owning assets that don’t move up and down in perfect tandem – in other words, by diversifying our holdings – we can reduce the overall volatility of a portfolio and, all else equal, increase its compounded returns.
By definition, good diversification means always owning some losing investments in your portfolio.
- You know in advance that by choosing to be a diversified investor, you will undoubtedly always have a part of your portfolio that disappoints.
This means that whether or not you will regret owning a globally diversified portfolio could depend on whether you focus more on whether the ultimate outcome was “good” or “bad,” rather than being concerned with whether the decision-making process itself was good or bad.
To minimize regret, it helps to evaluate the process by which you made decisions (in this case, understanding the reasoning and math behind diversification) rather than focusing on specific outcomes (like, for example, the fact that International stocks lagged the S&P 500 over the last decade).
Focusing on Outcomes Rather Than Process Increases Regret
If you find yourself regretting ownership of International stocks due to their relative underperformance during the past decade, then you might be unfairly assuming a bad outcome was the result of a bad decision.
Evaluating the quality of a decision based on its outcome sets you up to experience more regret than necessary because risk and randomness can make even the best decisions yield bad results.
- It also assumes a binary that isn’t actually there; there’s not just the best decision and the wrong one. There’s usually a second-best choice, a third, and so on.
The only rational way to make decisions about an unknowable future is using probability.
- If we go back to the idea of global diversification, the evidence shows us it’s a strategy with a very high probability of success.
- High probability, however, doesn’t mean guaranteed.
- Is it always the very best choice? No, not always.
- But financial theory tends to work pretty well if you give it enough time.
While owning International stocks didn’t add to returns over the last decade, they were additive over the past 20 years, which is a time horizon more academically aligned with the phrase “long-term.”
And if we look at the choice to own International stocks a decade ago, evaluating the evidence you had at the time and decision making process would be the real way to assess the decision.
Interestingly, when I think back to a decade ago, the people who were looking to make a change in their portfolio were often clamoring for more International and Emerging Market exposure because we had just experienced a ten-year period from 2000-2009 in which the S&P 500 had a negative average annualized return.
In my experience, investors that were disappointed by having less International exposure a decade ago are often the same ones that are disappointed by not having more U.S. exposure today.
Perhaps this highlights the importance of another piece of thinking probabilistically, and that’s understanding the thesis and range of outcomes of a particular strategy in advance.
- If you added International in 2010 because it had better performance and you were hoping the change would increase your returns, you had a bad outcome and a bad process.
- But owning International for the purposes of diversification is a totally different story.
Knowing a sound investment process in place ought to minimize regret by providing the mental bandwidth to acknowledge a bad outcome wasn’t necessarily the result of a poor decision.
Common Opportunities to Minimize Regret
The opportunity for experiencing regret as an investor expands well beyond global diversification. You need a good decision-making process for a number of investment choices you’ll face over the course of a lifetime, such as:
- Should I invest my cash in the stock market right now?
- Should I overweight my portfolio to value stocks and underweight growth stocks to seek higher expected returns?
- Should I replace my bonds with a higher-yielding alternative?
- Should I invest in bitcoin?
- Should I invest in an ESG portfolio to more closely align my portfolio with my values?
There will always be a “best” or “optimal” answer to these questions after the fact. But you can minimize regret by understanding the evidence supporting a decision, using a probabilistic approach, and thinking through how you might feel about a variety of potential outcomes.
And once you minimize regret, it’s much easier to stay the course and let financial theory do its thing.
As a reminder, you can visit www.TheLongTermInvestor.com to submit questions for me to answer on the podcast. Today’s question is about retirement account rollovers:
Do you think the stock market is in a bubble? It doesn’t make sense to me why it would be up given all the problems our country faces. I’ve been thinking about paring back my equity exposure because it seems like we must be due for a correction.
So, I don’t love the term bubble, in part because I feel like it gets way overused. Part of what makes something a bubble is that it isn’t easily identified.
The question was pretty broad in their concern of “the problems our country faces,” but those are all pretty well known. They’re already priced into the market.
I’ve heard more specific concerns from clients, friends, and family about our country or the economy or politics – but again, rarely do I hear anyone raise an issue that isn’t already well known among participants.
I like the way Cliff Asness defines a bubble: “The term should indicate a price that no reasonable future outcome can justify.”
I’m not sure that stocks are at prices that fits this definition.
Part of me wonder if it’s a lack of understand of how markets work that drives the doubt and apprehension about the stock market.
Market prices are set on the basis of supply and demand:
- Participants take all available information, and there is a lot of information from what you read in the paper and what companies release in earnings reports, to specialized data from satellite imagery or custom data sets that are privately owned by those seeking to profit from them
- When there are more buyers than seller, prices go up.
- On a day when the market is up, basically the market thinks that profits will be higher in the future or (due to supply and demand) they are willing to pay more for those future profits than the day before.
When you break down returns, good or bad, you can attribute them to three things:
- Changes in Earnings (this makes intuitive sense, as it earns more, it boosts the stock)
- Reinvested dividends (share buybacks or actual dividends that you reinvest)
- Most important (and most uncertain) is Changes in Valuation – really a measure that blends psychology and calculus
- Investors are trying to predict future cash flows to determine what different companies are worth today
- But confidence can impact how much someone is willing to pay for those future earnings, and that’s where the psychology kicks in. This psychology can cause investors to pay more or less for the same dollar of earnings on any given day.
So think about this framework when trying to understand why market prices are where they are today – or anytime for that matter.
Now, I’ve mostly been focused on the fact the bubble portion of this question, but I think we can actually think a little bit about minimizing regret when addressing the comment about paring back stock exposure because it feels like we are due for a correction.
As CIO at a large firm like Plancorp, plus being in the media as well as questioned by friends and family – I feel like I’m always talking to someone who feels like we are due for a correction.
I’ll admit, I’m hearing the concern a bit more these days than I have in most of the run up as the economy’s wounds from the pandemic began healing, but here’s what I typically ask people concerned about a correction:
- How big of a correction are you expecting? Because typically 10% drops occur on average every 12 months, roughly. So are you worried about a 10% drop, because that’s sort of the cost of equity investing.
- 20% drops happen roughly every 3.5 years. Again roughly. And it’s not like these things operate on a schedule.
- Again, I’d say this is mostly the cost of investing. You have to be willing to tolerate these types of losses in order to earn the higher returns that stocks offer. Long Term Investors must know that a 20% drop, while perhaps frightening in the moment and unique from past 20% drops, is incredibly normal.
- The 30+ % drops happen roughly once a decade. Again, I’m just talking about averages here. These types of drops tend to happen for reasons that are completely unpredictable.
So ask yourself, when you are worried about a correction, how big of a drop? And how long until it recovers? Are you worried about a permanent 40% decline, because the probability for that kind of permanent loss for a globally diversified portfolio is extremely low.
And let’s say you do sell out of stocks or reduce your stock exposure from, say, a 60/40 portfolio to a 40/60 portfolio – or whatever. How will you know when to ramp stocks back up to your original allocation?
See, that’s the hard thing about timing the market: you have to time it right twice.
Also, there might be taxes to consider. I live in St. Louis, where high income individuals likely pay almost 30% in taxes when you consider long-term capital gains, investment income tax, and state tax. If you have higher state taxes, whether you capital gains are long or short-term, that will make a big difference.
It’s one thing to realize taxes as part of a financial plan that requires you liquidate part of your portfolio to meet living expenses, but timing the market to try and avoid a loss and in the process suffering from your own personal bear market that the taxes create – I don’t know, that just doesn’t make sense to me.
Plus, remember your time horizon. What’s the money for? It’s unlikely you need to liquidate your entire portfolio to meet living expenses. If you’re saving for retirement, short-term declines in market (even if those “short-term” declines take a year or two to recover) means that you’d be better off riding the market waves up and down. Same goes for portfolios that are intended for the next generation. Same definitely goes for younger investors with multiple decades until retirement.
We never know when the next correction or bear market will occur. But we should expect them to occur with a similar frequency and magnitude as we have experienced in the past. And that means we can plan for them. And it’s much better to plan than predict.
About the Podcast
Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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