Advisors can help their clients through a preventive approach or by changing their mindsets
When it comes to investment regrets, the best approach is to create a preventive portfolio.
That’s the idea put forth by Nobel Memorial Prize-winning behavioural economist Daniel Kahneman during the recent Morningstar Investment Conference held in Chicago. At one point, he recounted a time when he was working with a team that specialized in “sort of planning, financial advising for very wealthy people.”
“The idea that we had was to develop what we called a ‘regret-proof policy,” said Kahneman, as reported on ThinkAdvisor. “Even when things go badly, they are not going to rush to change their mind or change and to start over.”
In pursuing this “regret minimization,” as he called it, advisors could explore possible situations that people may not be thinking of. That includes the possibility of feeling regret and wanting to reverse a pre-planned decision — generally a bad idea when it comes to financial plans.
“We had people try to imagine various scenarios, in general, bad scenarios,” he explained. “The question was, at what point do you think that you would want to bail out? That you would want to change your mind?”
The exercise revealed that most of the participants, even the extremely wealthy ones, were extremely loss-averse. To minimize the risks of making poor decisions in the wake of a loss, Kahneman and the team he was working thought of having people set up two portfolios: one that’s risky and one that’s much safer.
The clients decide how much of their assets to put in each portfolio, and they see the results from each one separately. According to Kahneman, one of them will always do better than the market, which gives people some sense of accomplishment.
But what if someone is limited to only one portfolio? Patrick Lach, an associate professor of finance at Bellarmine University and founder of Lach Fiinancial, recently suggested another approach — one that involves a change in mindset.
“Too often, when making financial decisions, we judge the wisdom of a decision based on the outcome,” he wrote in the Wall Street Journal. “In other words, people think that if they regret a financial decision, it must have been a mistake.”
To illustrate, he pointed out that most people would think that an investor who put her whole life savings into a high-tech IPO that advanced 80% within six months made a smart decision, even though no financial expert would have advised her to do it. Conversely, someone who invested in a passive, low-cost index fund that dropped 30% last year would likely consider it a bad one in hindsight, but few objective financial experts would advise against it.
“Investors must use the past as a guide when weighing the risk and reward of different decisions,” Lach said, “but they should also consider the amount of risk they can afford to take and the amount they are willing to take.”