"How to invest without regret" - Daniel Kahneman

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WiscoTrout
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"How to invest without regret" - Daniel Kahneman

Post by WiscoTrout »

Stumbled on an article this morning that I found interesting https://qz.com/1312744/how-to-invest-wi ... economist/. As someone who has struggled with loss aversion in investing, I've always thought Kahneman's behavioral economics theories to be spot on.

I find interesting that the two portfolio solution he is proposing ("two portfolios, one risky and one safer, based on the “regret propensity” for each individual investor") is nothing more than a reasoned asset allocation based upon someone's stomach for risk. Comforting to see that a lot of the advice shared on Bogleheads has grounding in behavioral economics. :)
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Re: "How to invest without regret" - Daniel Kahneman

Post by Reb Tevye »

Two portfolios, one risky, one safe.

That sounds like my one portfolio... with stocks and bonds. :happy
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Re: "How to invest without regret" - Daniel Kahneman

Post by triceratop »

Interesting piece, thank you.

I find it useful to regret many of my investing decisions, but still make them because they are, at the time, the rational thing to do. The human mind likes to fool you into thinking your decision making is flawed if adverse events occur but this is a fallacy. Regrets are wonderful - it means I am taking risk.
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Re: "How to invest without regret" - Daniel Kahneman

Post by Ron Scott »

Reb Tevye wrote: Thu Jun 28, 2018 9:10 am Two portfolios, one risky, one safe.

That sounds like my one portfolio... with stocks and bonds.
Kahneman, a true Scholar as classically defined, understands that people hate to lose more than they love to win and is attempting a work-around on the propensity of the average investor to sell equities during the deeper bear markets.

From the article...
The solution the team came up with was to design two portfolios, one risky and one safer, based on the “regret propensity” for each individual investor. The two portfolios are then managed and reported separately. This establishes a psychological distance between the two and allows the investor to feel safer, even though, in reality, they are both part of the same portfolio.

Usually, one of the portfolios is always doing better than market. This fact alone means that investors are less likely to panic, feel regret, and to want to change their minds when something does go wrong. According to Kahneman, even remembering that you actively imagined about how it would feel to have the value of your investments plunge is valuable.


Look at it from the perspective of a psychologist conducting an experiment:

You take one group of people and give them the standard psychological treatment that BHers use. You tell them to take their Vanguard risk-tolerance test, set an asset allocation based on the results and warn them again and again DO NOT SELL STOCKS IN A DOWNTURN!!!

Another group gets Kahneman's treatment with 2 separate funds and the imaging of equity loss, etc.

Then you compare the groups on a measure of success, such as % of equities sold in a downturn and see which approach is better.

I don't know which is better, but I'd rather see people looking at things in a more scientific way then blindly following the status quo.

When I worked we had a saying: Spend the company's money like it's your own and invest your own money like you'd invest the company's. Most people KNOW what to do, but doing it in the face of adversity requires a deeper understanding of the psychology involved.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.
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Re: "How to invest without regret" - Daniel Kahneman

Post by michaeljc70 »

Interesting, but if that really fools people....

Instead of just asking clients how much they are willing to lose in a downturn, that should be matched with how much are they willing to not gain in an upturn!
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Re: "How to invest without regret" - Daniel Kahneman

Post by livesoft »

I smell buckets. Buckets of ....
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Re: "How to invest without regret" - Daniel Kahneman

Post by Ron Scott »

Another (short) Kahneman article:

Nobel Laureate Has Most Awkward Dinner Ever With Financial Advisers He Just Destroyed

Nobel laureate Daniel Kahneman claims in his book Thinking, Fast And Slow that the stock picking industry is built largely on an "illusion of skill."

Among the evidence he gives is a study he did of a group of investment advisers. Kahneman analyzed their returns over eight years to see how consistently advisers performed over time. While he expected large variation in performance, he was surprised to see that the correlation was basically zero.

"The results resembled what you would expect from a dice-rolling contest, not a game of skill," he writes.

How did the advisers respond to evidence of their uselessness? With the most awkward dinner party — and car ride — ever:

On the evening before the seminar, [colleague] Richard Thaler and I had dinner with some of the top executives of the firm, the people who decide on the size of bonuses ...

Our message to the executives was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were sophisticated enough to see the implications, however we politely refrained from spelling out. We all went on calmly with our dinner, and I have no doubt that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions—and thereby threaten people's livelihood and self-esteem—are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide base-rate information that people generally ignore when it clashes with their personal impressions from experience.

The next morning, we reported the findings to the advisers, and their response was equally bland. Their own experiences of exercising careful judgment on complex problems was far more compelling to them than an obscure statistical fact. When we were done, one of the executives I had dined with the previous evening drove me to the airport. He told me, with a trace of defensiveness, "I have done very well for the firm and no one can take that away from me." I smiled and said nothing. But I thought, "Well, I took it away from you this morning. If your success was due mostly to chance, how much credit are you entitled to take for it?"
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.
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Re: "How to invest without regret" - Daniel Kahneman

Post by CULater »

WiscoTrout wrote: Thu Jun 28, 2018 8:50 am Stumbled on an article this morning that I found interesting https://qz.com/1312744/how-to-invest-wi ... economist/. As someone who has struggled with loss aversion in investing, I've always thought Kahneman's behavioral economics theories to be spot on.

I find interesting that the two portfolio solution he is proposing ("two portfolios, one risky and one safer, based on the “regret propensity” for each individual investor") is nothing more than a reasoned asset allocation based upon someone's stomach for risk. Comforting to see that a lot of the advice shared on Bogleheads has grounding in behavioral economics. :)
Isn't this a little like the idea proposed by Bill Bernstein and others of a floor and upside ("risk") portfolio strategy for retirement investing? The floor portfolio is a very conservative portfolio of fixed income investments that provides a relatively stable source of income, and the risk portfolio is a portfolio largely allocated to stocks or similar investments.
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Re: "How to invest without regret" - Daniel Kahneman

Post by WiscoTrout »

CULater wrote: Thu Jun 28, 2018 10:12 am
WiscoTrout wrote: Thu Jun 28, 2018 8:50 am Stumbled on an article this morning that I found interesting https://qz.com/1312744/how-to-invest-wi ... economist/. As someone who has struggled with loss aversion in investing, I've always thought Kahneman's behavioral economics theories to be spot on.

I find interesting that the two portfolio solution he is proposing ("two portfolios, one risky and one safer, based on the “regret propensity” for each individual investor") is nothing more than a reasoned asset allocation based upon someone's stomach for risk. Comforting to see that a lot of the advice shared on Bogleheads has grounding in behavioral economics. :)
Isn't this a little like the idea proposed by Bill Bernstein and others of a floor and upside ("risk") portfolio strategy for retirement investing? The floor portfolio is a very conservative portfolio of fixed income investments that provides a relatively stable source of income, and the risk portfolio is a portfolio largely allocated to stocks or similar investments.
And it's also similar to the "bucket" strategy that I've read about. And although the buckets are based upon time horizons (near, medium term, far out), at their essence it's about having discrete buckets of safety/growth potential ratios. I think even Nassim Taleb's "barbell" strategy fits this as well.
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Re: "How to invest without regret" - Daniel Kahneman

Post by Reb Tevye »

livesoft wrote: Thu Jun 28, 2018 10:09 am I smell buckets. Buckets of ....
That’s funny.
"So, what would have been so terrible if I had a small fortune?"
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Re: "How to invest without regret" - Daniel Kahneman

Post by ncbill »

CULater wrote: Thu Jun 28, 2018 10:12 am
WiscoTrout wrote: Thu Jun 28, 2018 8:50 am Stumbled on an article this morning that I found interesting https://qz.com/1312744/how-to-invest-wi ... economist/. As someone who has struggled with loss aversion in investing, I've always thought Kahneman's behavioral economics theories to be spot on.

I find interesting that the two portfolio solution he is proposing ("two portfolios, one risky and one safer, based on the “regret propensity” for each individual investor") is nothing more than a reasoned asset allocation based upon someone's stomach for risk. Comforting to see that a lot of the advice shared on Bogleheads has grounding in behavioral economics. :)
Isn't this a little like the idea proposed by Bill Bernstein and others of a floor and upside ("risk") portfolio strategy for retirement investing? The floor portfolio is a very conservative portfolio of fixed income investments that provides a relatively stable source of income, and the risk portfolio is a portfolio largely allocated to stocks or similar investments.
So just another variation on the "rising equity glide path" model?
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Re: "How to invest without regret" - Daniel Kahneman

Post by grok87 »

I’m following an approach that is similar called the 3-legged stool.

Details here

viewtopic.php?f=10&t=245377
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Re: "How to invest without regret" - Daniel Kahneman

Post by 2015 »

The only purposes of "regret" is to learn something. Hopefully, we will shy away from having to learn our "regrets" more than once. I don't regret anything I've ever done because I always expanded into something bigger and better as a result of whatever failure occurred.

Life is so overwhelmingly packed with possibility the very last thing I want to waste my "regrets" on is investing. Were I interested in tossing around money gambling, I'd go to Vegas first because at least I might get some free booze in the process of my entertainment.
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Re: "How to invest without regret" - Daniel Kahneman

Post by CULater »

I used to do something like this back when I was teaching and contributing to TIAA-CREF. You only had two choices then: TIAA traditional, and CREF stock. So, I put 50% in each. Psychologically, they seemed like two different retirement accounts. TIAA was safe and conservative like a bank CD, and CREF was the riskier, growth side. Each account grew separately. Back then, the idea of "rebalancing" was not even an idea. The only thing I regret now is that I didn't do something like 75% CREF and 25% TIAA instead of 50/50.
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Re: "How to invest without regret" - Daniel Kahneman

Post by Valuethinker »

CULater wrote: Thu Jun 28, 2018 1:44 pm I used to do something like this back when I was teaching and contributing to TIAA-CREF. You only had two choices then: TIAA traditional, and CREF stock. So, I put 50% in each. Psychologically, they seemed like two different retirement accounts. TIAA was safe and conservative like a bank CD, and CREF was the riskier, growth side. Each account grew separately. Back then, the idea of "rebalancing" was not even an idea. The only thing I regret now is that I didn't do something like 75% CREF and 25% TIAA instead of 50/50.
This was precisely Franco Modigliani (who shared the Nobel Prize with Merton Miller)'s investment strategy. 50-50. He was a wise man.

You are "regretting" something your past self could not have known. In truth, high interest rates (vs. history) over the time period meant TIAA Traditional did quite well, I believe. Had we gone through an extended bear market like 1966-1980 you would have been glad for it.

It is just that stocks went up a lot more over the time period. But, I put money into stock markets in 2000 that is just about breakeven, now -- UK stockmarket has not done as well as US (we didn't have easy access to global or US stock index funds in those days) and I also fell for home country bias.

So I could "regret" the money I put into stocks at that time.

My biggest regret is that I never held bond funds -- just stocks + cash. Had I put a decent slug of my cash into bond funds, I would have achieved much higher returns, particularly in the last few years.

But, again, I have to be kind to my ex ante self (then) who is now my ex post self (now) ;-).
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Re: "How to invest without regret" - Daniel Kahneman

Post by beardsworth »

Valuethinker wrote: Fri Jun 29, 2018 2:56 am But, again, I have to be kind to my ex ante self (then) who is now my ex post self (now) ;-).
That seems like a good rule, in general, for people to be kind to their ex post selves, even when they've done something that makes them want to hit themselves over the head with a post. :)
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Re: "How to invest without regret" - Daniel Kahneman

Post by goblue100 »

As to the article, I'm scratching my head. If we imagine investor one with a 1M overall portfolio, and portfolio 1 is 100% stocks ($500,000), and portfolio 2 is 100% bonds ($500,000). Now we turn the clock back to 2008 and 2009 and compare it to investor two with a 1M 50/50 portfolio.

On 2/18/2009 investor two's 50/50 portfolio is down almost $250,000. The balance is $778,000. Investor one has a bond portfolio worth $519,000. A gain, which makes him happy. Investor one also has a stock portfolio, which is now worth $258,000, almost a 50% loss. This would make him very sad. He also has the same amount of money as investor two.

I'm not sure how this helps someone with loss aversion. Seeing the losses concentrated in one portfolio would make it worse, at least for me.
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Re: "How to invest without regret" - Daniel Kahneman

Post by linenfort »

Ron Scott wrote: Thu Jun 28, 2018 10:10 am Another (short) Kahneman article:

Nobel Laureate Has Most Awkward Dinner Ever With Financial Advisers He Just Destroyed

Hilarious :D
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Re: "How to invest without regret" - Daniel Kahneman

Post by goingup »

goblue100 wrote: Fri Jun 29, 2018 8:15 amI'm not sure how this helps someone with loss aversion. Seeing the losses concentrated in one portfolio would make it worse, at least for me.
I'm totally on board with using a few techniques to minimize panic when markets crater. It's about creating space so irrationality doesn't take over.

Kahneman:
"The two portfolios are then managed and reported separately. This establishes a psychological distance between the two and allows the investor to feel safer, even though, in reality, they are both part of the same portfolio."

From my own experience in 2008-2009 it was much easier to look at 401K statements where a single balanced fund struggled but didn't hemorrhage, than our taxable account which I feared could go to zero. (That was the panic talking.)

The majority of us are probably loss averse, though the degree varies by the individual. I don't think it's a static knowable characteristic until things get dire. Best to have thought through a few proven techniques vetted by a Nobel laureate which may mitigate poor behavior.
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Re: "How to invest without regret" - Daniel Kahneman

Post by michaeljc70 »

goblue100 wrote: Fri Jun 29, 2018 8:15 am As to the article, I'm scratching my head. If we imagine investor one with a 1M overall portfolio, and portfolio 1 is 100% stocks ($500,000), and portfolio 2 is 100% bonds ($500,000). Now we turn the clock back to 2008 and 2009 and compare it to investor two with a 1M 50/50 portfolio.

On 2/18/2009 investor two's 50/50 portfolio is down almost $250,000. The balance is $778,000. Investor one has a bond portfolio worth $519,000. A gain, which makes him happy. Investor one also has a stock portfolio, which is now worth $258,000, almost a 50% loss. This would make him very sad. He also has the same amount of money as investor two.

I'm not sure how this helps someone with loss aversion. Seeing the losses concentrated in one portfolio would make it worse, at least for me.
The concept, which I think is silly to me but might work on at some people, is that they will see that one portfolio went up and one went down and subdue the feelings when looking at the one that went down. In reality, it is just a trick. For people like me that look at the total of all my investments (across all accounts/portfolios), this would do nothing. I could see this being more effective for people that get paper statements and don't use aggregating tools like Quicken, Mint, Betterment or whatever.
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Re: "How to invest without regret" - Daniel Kahneman

Post by DartThrower »

I see my stocks and bonds as an integrated whole. No need for mental accounting of any kind ever. Mental accounting makes one prone to rationalizing poor investment decisions. For instance one might be tempted to run up credit card debt because "at least my bond portfolio is safe".

YMMV.
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