Regret Minimization

Investors have a habit of thinking in terms of extremes. Active or passive. All-in the markets or all-out. Stocks are either topping out or about to bottom. Markets are perfectly efficient or wildly inefficient.

It’s much easier to go to the extreme viewpoints because it acts as something of a mental shortcut. The brain is constantly looking for these shortcuts as a way to conserve energy. This line of thinking leads people make binary decisions, which is a difficult place to be because (a) markets are hard and (b) things aren’t always black or white when it comes to financial choices.

Investors have been asking for a number of years now whether or not it’s time to get out of U.S. stocks. Larry Swedroe discussed the idea of higher expected returns in foreign stocks in a piece from this past week:

Clearly, if investors want the higher expected returns, they should consider tilting their portfolios (have a higher allocation) to international developed-market value stocks and emerging markets value stocks. However, earning the highest expected returns isn’t generally an investor’s only objective, or sole consideration.

If earning the highest expected returns possible was, in fact, an investor’s sole consideration, we would likely concentrate portfolios to a greater degree than is prudent.

Yes, you could increase your expected return today by lowering your allocation to U.S. value stocks and more heavily weighting international developed, and especially emerging market, value stocks. However, doing this would also decrease your level of diversification, increasing idiosyncratic risks. Again, we have the same trade-off.

Swedroe brings up a great point on how to think about risk in a way that’s not very apparent to most investors at first glance. Many simply want a buy or sell answer so they can move on. Risk takes many different forms in the markets. No matter what you do, it never completely goes away. Your risks just change based on how you’re positioned. It becomes a game of pick your poison.

This is why I think it’s so important for investors to understand the concept of regret minimization. I discussed this topic in my book:

Investing really comes down to regret minimization. Some investors will regret missing out on huge gains while others will regret participating in huge losses. Which regret will wear worse on your emotions? Missing out on future gains or future losses? Diversification within a well-thought-out asset allocation is your best option to minimize these two regrets. You’ll never go broke practicing diversification, but you must be willing to accept short-term regrets in place of long-term ones. Diversification also helps control your behavior. You never completely miss out on the biggest gains while you never fully participate in the biggest losses.

Of course, diversification can’t completely protect you from poor performance over days, months, or even years. You have to be able to withstand losing money at some point to be able to make money. But diversification does protect investors from experiencing numerous poor cycles or decades, which is where real risk resides. Diversification is about accepting good enough while missing out on extraordinary so you can avoid terrible. Famed value investor Howard Marks once said, “Here is part of the trade-off with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.”

Swedroe and Marks both mentioned the word ‘trade-off.’ In many ways, every investment decision you make requires the acceptance of certain trade-offs. That’s how risk works. You can’t protect your portfolio from every eventuality. There’s no right or wrong answer for every investor. It really comes down to finding the trade-offs you’re comfortable dealing with.

But I think a lot of investors delude themselves into thinking that they can some how position their portfolios in a way that completely eliminates all forms of risk. There’s no way to completely eliminate risk from the markets. It really comes down to figuring out which risks are necessary, which risks you want to avoid and which risks will minimize your regrets over the long run.

Source:
Highest Expected Returns Not Always Best (ETF.com)

Futher Reading:
Perma-Arguments