How Regret Can Improve Investing

Unhappiness about the stocks you should have bought can be a useful lesson for investors

John Rekenthaler 27 July, 2018 | 12:44PM

Investing emotions

Have you ever invested via time travel? Calculated how much money you would possess had you known the financial future? I confess to such a daydream. It is February 1975, my parents inquire what I wish for my birthday, and I respond, “As much Berkshire Hathaway (BRK.A) stock as you can buy for $1,000, please.”

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. Let’s jump to 1989, 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.

We cannot perceive what is to come. But 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.

Target-Date Funds Over Cautious

To understand how regret informs our real-life investments, consider target-date funds. Nine years ago, nobody criticised 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.

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 Aren’t these figures, which are so commonly used in the investment world, a bit out of date?"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. 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.

However, one side of the argument could only be published now, and the flip side only then. 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.

Picking Unpopular Shares

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 equity 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: US 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.

It is easy to cast aside investments that have caused pain, but difficult to scrap those that have provided pleasure.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Berkshire Hathaway Inc A314,060.00 USD0.19
About Author John Rekenthaler

John Rekenthaler  is vice president of research for Morningstar.