Based on analysis involving the input of Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.
Insurance companies regularly implement a two-portfolio approach as part of their Liability Driven Investment (LDI) program: a liability matching portfolio and a return seeking portfolio.
It is also consistent with a Goal Based Investing approach for an individual: Goal-hedging portfolio and a performance seeking portfolio. #EDHEC
Although there is much more to it than outlined by the article below, I find it interesting the solution of two portfolios came from the angle of behavioural economics.
I also think it is an interesting concept given recent market volatility, but also for the longer-term.
Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.
“The idea that we had was to develop what we called a ‘regret-proof policy,’” Kahneman explained. “Even when things go badly, they are not going to rush to change their mind or change and to start over,”.
According to Kahneman, the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are “really not the same.”
In developing a “regret-proof policy” or “regret minimization” Portfolio allows advisors to bring up “things that people may not be thinking of, including the possibility of regret, including the possibility of them wanting to change their mind, which is a bad idea generally.”
In developing a regret proof portfolio, they asked people to imagine various scenarios, generally bad scenarios, and asked at what point do you want to bail out or change your mind.
Kahneman, noted that most people — even the very wealthy people — are extremely loss averse.
“There is a limit to how much money they’re willing to put at risk,” Kahneman said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”
The investment solution is for people to “have two portfolios — one is the risky portfolio and one is a much safer portfolio,” Kahneman explained. The two portfolios are managed separately, and people get results on each of the portfolios separately.
“That was a way that we thought we could help people be comfortable with the amount of risk that they are taking,” he said.
In effect this places a barrier between the money that the client wants to protect and the money the client is willing to take risk on.
Kahneman added that one of the portfolios will always be doing better than market — either the safer one or the risky one.
“[That] gives some people sense of accomplishment there,” he said. “But mainly it’s this idea of using risk to the level you’re comfortable. That turns out to not be a lot, even for very wealthy people.”
I would note a few important points:
- The allocation between the safe and return seeking portfolio should not be determined by risk profile and age alone. By way of example, the allocation should be based primarily on investment goals and the client’s other assets/source of income.
- The allocation over time between the two portfolios should not be changed based on a naïve glide path.
- There is an ability to tactically allocate between the two portfolios. This should be done to take advantage of market conditions and within a framework of increasing the probability of meeting a Client’s investment objectives / goals.
- The “safer portfolio” should look more like an annuity. This means it should be invested along the lines that it will likely meet an individual’s cashflow / income replacement objectives in retirement e.g. a portfolio of cash is not a safe portfolio in the context of delivering sufficient replacement income in retirement.
Robust investment solutions, particularly those designed as retirement solutions need to display Flexicurity. They need to provide security in generating sufficient replacement income in retirement and yet offer flexibility in meeting other investment objectives e.g. bequests. They also need to be cost effective.
The concepts and approaches outlined above need to be considered and implemented in any modern-day investment solution that assists clients in achieving their investment goals.
Such consideration will assist in reducing the risk of clients adjusting their investment strategies at inappropriate times because of regret and the increased fear that comes with market volatility.
Being more goal focussed, rather than return focused, will help in getting investors through the ups and downs of market cycles. A two-portfolio investment approach may well assist in this regard as well.
Please see my Disclosure Statement
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.