When the coronavirus outbreak played havoc with the markets in the first quarter of 2020, I had a new client, a couple with a lot of money they needed to invest. As the S&P 500 hit its steepest decline, I was ready to invest their cash and diversify their holdings according to their agreed upon investment strategy, but my clients weren’t. They hesitated and insisted on holding onto their money in cash rather than investing, because they were worried the markets could go lower and that they would lose the savings they had worked so hard to earn.
Q2 2020 hedge fund letters, conferences and more
The markets started to improve shortly after, but because my client had opted to stay on the sidelines, they were unable to take part in the market recovery and missed out on gains that approached 30 percent. Did they regret their decision to delay? Absolutely. So did I.
“Regret is probably the greatest enemy of good decision making in personal finance,” according to Nobel laureate and behavioral economist Daniel Kahneman, the author of Thinking, Fast and Slow. In the case of my client, the fear of regret they might have experienced by investing caused them to make a suboptimal decision. (I call this phenomenon “fear of dumb decisions,” or FODD.) But it can work in the opposite way as well. For example, in a bull market, fear of regret can cause some investors to ignore warning signs and continue to take on risk because they have a fear of missing out (sometimes abbreviated as FOMO).
Emotional biases infiltrate the way we make decisions every day, and behavioral economists have postulated that acting on investor mistakes can make it easier to time the market. That idea doesn’t wash, however, with another Nobel laureate, Eugene Fama, who serves as a director and consultant to Dimensional Fund Advisors. Considered the “father of modern finance,” Fama developed the efficient market hypothesis, which holds that at any given time, stock prices reflect all available information, and that markets react quickly to incorporate new public information. He continued to defend that position in a 1999 article in the Chicago Booth Review.
The Keys to "No Regrets" Investing
In an interview with Morningstar, Kahneman suggested that although behavioral biases could be used for good or evil, financial advisers could use regret theory in a positive way when working with clients. In his interview with Morningstar, Kahneman cited a practice that he had developed with his colleagues: creating a measure of projected regret by working with the client to crystallize his or her level of loss aversion. Based on that understanding, he and his team would then create a two-part portfolio for the client, one containing the assets the client was willing to risk, and the other containing the assets the client wanted to protect.
From the point of view of the investor, Kahneman urges trusting algorithms over people and taking a broad view of the markets, by understanding that a decision is one of many in a class of decisions the investor might make. He also cautions investors to seek good advice.
I would add to those suggestions that taking a long-term view of the markets is also important. The markets experience many ups and downs based on the news of the day, but over time, they tend to also reward investors who have the discipline to stick with their strategies.
Dealing with uncertainty is one reason why investors earn a return. After all, if everybody knew everything about the markets, there would be no risk for which investors can be rewarded. While major events, like the coronavirus, make us fear the unknown, that unknown is the very reason why we have the potential to earn more than the risk-free rate.
Seek the Help of an Interpretive Adviser
The best way to avoid regret, in my opinion, is to have a conversation with your financial adviser while things are calm and you’re not feeling pressured to make a decision. As you develop your financial goals and discuss them with your adviser, take a moment to also discuss the potential scenarios that might make you afraid. These could include anything from market volatility, including a sudden drop or an escalating bubble, to other factors, such as how soon you think you’ll need to draw on your investments.
In his book, Being Mortal, author and surgeon Atul Gawande describes three types of doctors, and after reading Gawande’s description, I realized that financial advisers could be categorized in the same way. Gawande writes:
- The paternalistic doctor tells patients what to do,
- The informative doctor sits down with you and goes through all of the different options you have regarding your particular health issue However, the reasons why one option might be better than another are not fully explained. He or she doesn’t assist you when it comes to making decisions.
- The interpretive doctor gives you information and helps you understand and focus on making the best decision for yourself. They are on the journey with you.
With financial advisers, some are paternalistic, telling you their strategies and insisting you should follow them. Others are informative, but they fail to help you fully understand the strategies they implement. An interpretive adviser takes you through a process that educates you on all of your options. He or she helps you sift through the incessant, confusing noise of the market and the media with the goal of serving you and your family. In my view, an interpretive adviser provides the most value.
My client was coming on board at a time when it seemed the markets were in freefall, and while I was unable to convince them to get started investing right away, we just kept talking, and eventually, I was able to help them capture a portion of the market’s recovery. With that rough spot for perspective, I now have a better understanding of their risk tolerance, as well as an idea of the circumstances that might make them feel regret. As a result, we have a much stronger relationship and a higher level of trust. Having an occasional regret is normal. How you choose to deal with potential regrets can make you a much stronger investor.
