Think about the major choices you’ve made in your life. Picking a career path, choosing a life partner, deciding to have children, changing jobs – these are high-stake decisions because each forces you to set aside all possible futures except the one you ultimately choose.
Any potential future is completely unknowable in the present moment. But the act of choosing something, even if we don’t know whether it’s right or wrong, optimal or less so, gives us a sense of control and responsibility over our decision.
When the outcomes eventually reveal themselves, it’s easy to feel regret when they aren’t what we hoped or expected. And regret is painful – literally.
When I experience regret, it’s not just in my head. It feels like my heart swells up and makes it harder to breathe. It’s not pleasant, and it’s something I obviously prefer to avoid.
While I (unfortunately) don’t have the answers for minimizing regret you could feel about big life choices, I do have some wisdom to offer for investing.
How Regret Works
To start, it helps to understand where regret often comes from and why we experience it. We often feel regret when we can clearly envision the alternative paths we didn’t take and decide those paths would have been better than the one we ultimately chose.
It’s particularly easy to see the alternatives after the fact when you are an investor. Winning investments always find their way to the center of attention. They’re the subject of financial news segments, social media posts, and even conversations with friends or coworkers.
Investing is also highly quantifiable, which can lead us to believe there’s always an objectively optimal decision out there. If we spend enough time thinking or researching or looking, we could find it. And if there’s an optimal choice, there’s also a wrong one. Knowing that things can go wrong leads many investors to put a lot of pressure on themselves to get it right.
This is largely an illusion, of course; there is no perfect portfolio because we can’t know in advance what strategies or asset classes will win over any given time period. If we kick ourselves for missing an obvious opportunity, it’s probably because we conveniently forgot it was only “obvious” after the fact.
Hindsight bias is a normal working part of human memory, but it’s a feature that often causes a lot of unnecessary grief in the investment experience and can intensify feelings of regret.
How to Minimize Regret with Your Investment Decisions
In order to minimize regret about your investments, it’s useful to think about how you might feel in the future about the choices you make today with your portfolio.
Ask yourself, “In ten years, what would make me regret this decision? What are some ways this decision could lead to bad outcomes, and how would I feel in these scenarios?”
It’s also helpful to think deeply about whether you are more concerned about implementing a bad idea or missing out on a good one.
When the FDA evaluates a new drug, for example, they seek to minimize the chance of approving a drug that is not beneficial to people’s health or that causes bad side effects. In doing so, they simultaneously increase the probability of failing to approve a drug that would improve people’s health.
It’s a choice between making a Type I error and a Type II error. Minimizing one leads to a higher chance of realizing the other. The FDA must manage this tradeoff when approving safe drugs for the public, and investors must do it when determining the best strategy to use for their situation.
As you think about what would cause more pain – making a bad investment or missing a good one – you must remember that bad outcomes are not always the result of a bad decision; sometimes you simply get unlucky, or the probabilities don’t work out in your favor.
That’s why no investment action should be taken unless it is adequately supported by good evidence, which also requires that you have a good process for interpreting the evidence you have.
Evidence-Based Decision-Making Processes Can Help Reduce Regret
Let’s look at a specific example to see how you might use an evidence-based approach to evaluate an investment decision in the context of minimizing regret: the choice to own international stocks.
The case for owning international stocks centers on diversification – it’s less about directly increasing return and more about reducing risk, which ideally improves the amount of return you earn for the degree of volatility you assume. This is what asset allocators refer to as improving risk-adjusted return.
All else being equal, when comparing two portfolios with the same average annual return, the one with lower volatility will have higher compounded returns over time because compound interest works better with lower volatility returns. By owning assets that don’t move up and down in perfect tandem – in other words, by diversifying our holdings – we can reduce the overall volatility of a portfolio and, all else equal, increase its compounded returns.
By definition, good diversification means always owning some losing investments in your portfolio. You know in advance that by choosing to be a diversified investor, you will undoubtedly always have a part of your portfolio that disappoints.
This means that whether or not you will regret owning a globally diversified portfolio could depend on whether you focus more on whether the ultimate outcome was “good” or “bad,” rather than being concerned with whether the decision-making process itself was good or bad.
To minimize regret, it helps to evaluate the process by which you made decisions (in this case, understanding the reasoning and math behind diversification) rather than focusing on specific outcomes (like, for example, the fact that international stocks lagged the S&P 500 over the last decade).
Focusing on Outcomes Rather Than Process Increases Regret
If you find yourself regretting ownership of international stocks due to their relative underperformance during the past decade, then you might be unfairly assuming a bad outcome was the result of a bad decision.
Evaluating the quality of a decision based on its outcome sets you up to experience more regret than necessary because risk and randomness can make even the best decisions yield bad results. It also assumes a binary that isn’t actually there; there’s not just the best decision and the wrong one. There’s usually a second-best choice, a third, and so on.
The only rational way to make decisions about an unknowable future is using probability. If we go back to the idea of global diversification, the evidence shows us it’s a strategy with a very high probability of success. High probability, however, doesn’t mean guaranteed. Is it always the very best choice? No, not always. But financial theory tends to work pretty well if you give it enough time.
While owning international stocks didn’t add to returns over the last decade, they were additive over the past 20 years, which is a time horizon more academically aligned with the phrase “long-term.”
Evaluating the evidence that would lead you to opt for international diversification a decade ago will show you the decision-making process was sound. In fact, during the early portion of the 2010 decade, investors were clamoring for more International and Emerging Market exposure after the ten-year period from 2000-2009 when the S&P 500 had a negative average annualized return.
In my experience, investors that were disappointed by having less international exposure a decade ago are often the same ones that are disappointed by not having more U.S. exposure today.
Perhaps this highlights the importance of another piece of thinking probabilistically, and that’s understanding the thesis and range of outcomes of a particular strategy in advance. If you added International in 2010 because it had better performance and you were hoping the change would increase your returns, you had a bad outcome and a bad process.
Knowing you have a sound investment process in place should minimize regret by providing the mental bandwidth to acknowledge a bad outcome wasn’t necessarily the result of a poor decision.
Common Opportunities to Minimize Regret
The opportunity for experiencing regret as an investor expands well beyond global diversification. You will need a good decision-making process for a number of investment choices, including:
- Should I invest my cash in the stock market right now?
- Should I overweight my portfolio to value stocks and underweight growth stocks to seek higher expected returns?
- Should I replace my bonds with a higher-yielding alternative?
- Should I invest in bitcoin?
- Should I invest in an ESG portfolio to align my portfolio more closely with my values?
There will always be a “best” or “optimal” answer to these questions after the fact. But you can minimize regret by understanding the evidence supporting a decision, using a probabilistic approach, and thinking through how you might feel about a variety of potential outcomes.
And once you minimize regret, it’s much easier to stay the course and let financial theory do its thing.
For additional insight and personal wisdom on the subject, listen to Chief Investment Officer, Peter Lazaroff's podcast:
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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.