MATCHING CLIENTS WITH SUSTAINABLE INVESTMENT STRATEGIES

UNDERSTANDING EACH CLIENT’S “REGRET TOLERANCE”

Traditional risk analysis focuses exclusively on volatility as a measure of uncertainty - and while that is a good start, it is at best an incomplete analysis. We have shown that our understanding of risk must move beyond purely analytical measures; we must also examine the emotional responses that people have when they encounter returns that are far from their expectations. These unusual returns may be higher or lower than the average return they anticipated; both bring on an emotional response that may encourage investors to enter or exit the market, often abandoning their strategy at the worst time. This type of behavior has been well-documented as a cause for client portfolios underperforming the assets they hold.

We call these emotions “regret” because they stem from disappointment - over both decisions made and those not made. These “regretful” emotions are sometimes strong enough to drive investors to make ill-timed changes in their asset allocation. Worse yet, we see that one bad decision is often followed by the corresponding bad decision, further compounding the relative losses that these emotion-based trades tend to produce. A common example starts with investors “chasing performance” as they watch an asset they do not own reach extraordinary levels. Not wanting to miss out on future anticipated gains, they finally enter the market (likely near the top) only to see their asset value begin to decline. When it eventually loses value relative to its cost, they decide to “cut their losses” before the reversal of momentum further erodes their portfolio value. The other regretful situation involves exiting the market near its top (if the investor is lucky) only to miss out on the inevitable correction, as emotions delay reentry, and eventually their reentry value exceeds their prior exit value. Both unfortunate situations illustrate the “whipsaw” effect that regret can produce.

What is the solution to emotion-based trading driven by regret?

Our first paper identified regret as that part of return volatility that presents the greatest danger, since clients can only expect to achieve their return goals if they maintain their asset allocation strategies. That fundamental assumption is often overlooked. We define regret in practical terms that allow us to measure its severity and its likelihood of occurrence. We used those factors to define a “regret penalty” that we subtract from the expected return, giving us a “regret-adjusted return.”

We address the second step of regret management in this paper, as we develop and examine a range of regret sensitivities. Risk tolerance is an individual characteristic, and this applies to all aspects of risk, including regret. In terms of identifying an appropriate asset allocation for a client, we need to examine more than its return opportunity and volatility - we must also consider each client’s unique susceptibility to the regret inherent in each strategy. Only then can we find the strategy that the client is likely to maintain throughout the ups and downs of the market.

Our paper examines regret across a range of “regret tolerances” and across our three diversified strategies.

PROPER CONTEXT FOR REGRET MANAGEMENT: DIVERSIFICATION

Effective diversification begins with identifying the types of economic environments investors are likely to encounter, and then allocating to investments that are likely to benefit in each circumstance. By combining assets with complementary patterns of return, we hope to tighten the distribution of returns and minimize the extreme returns that drive regret.

Our approach focused on three contingencies:

• strong equity markets,
• weak equity markets and
• periods of extreme geopolitical stress.
• Our corresponding asset strategy for each included:
• Stocks: 70% US large cap and 30% small cap,
• Bonds: 20% cash and an equal mix of 10-year and 20-year Treasury bonds, and
• Real assets: equal mix of real estate and gold.

Our three asset allocations varied the equity exposure, while preserving an equal mix of bonds and real assets. We began with the 50-50 allocation of equity and “reserves” (the blend of bonds and real assets.) Then we added a more conservative strategy (1/3 equity) and a more aggressive strategy (2/3 equity.)

Here is a traditional view of our strategies, from the standpoint of one-year expected returns relative to volatility risk. This typical evaluation considers these strategies to be equally efficient. Clients would be matched to the strategy that best matched their return objective.

“That is where the traditional approach to risk ends; but it is where we are just getting started.”

DEFINING REGRET IN TERMS OF THE CLIENT

We developed a set of “trigger points” where a client’s emotions kick in, bringing on regret. These triggers define where the levels of gains and losses are considered “extraordinary” because they induce levels of emotion that could lead to decisions around timing the market. These are unique to each client, and so we prepare a set of “upside” and “downside” returns that cover the complete set of triggers that clients can use to understand their tolerance for regret risk.

We followed our guidance that losses carry twice the emotion of similar-size gains, and so our losses are generally half the amount of their associated gains. We balance each client’s tolerance for losing money (evidenced by the emotion of despair) as well as the fear of missing out on extraordinary gains in the market (the emotion of envy.) These are realistic scenarios that every client can consider, while honestly dealing with the visceral emotions that each may bring on. We believe that these practical and tangible values are highly relatable, and therefore more indicative of how clients truly feel about their exposure to the real ups and downs of the market. As such, we see this approach as superior to the typical investor questionnaire that many investment firms use to gauge each client’s so-called “risk tolerance.” The weakness of that approach comes from: a) the use of arcane statistics that few clients understand (i.e., the standard deviation of returns) and b) vague questions that do not convey any useful information (i.e., “Would you accept a reasonable amount of risk to achieve your target investment return?”)

Using our approach to regret, investment advisors can create understandable and relatable questions that provide a good sense of what levels of market turbulence would truly upset a client so much that they abandon their strategy. One such question might be: “Which level of loss would cause you to worry that you might not recover enough to meet your financial needs?” On the other side, the question could be: “How large a return would make you feel that you missed the boat on a great opportunity?”

Armed with these honest responses, we can begin calculating regret in terms of how each client really feels about holding on to their investments throughout a market cycle. This gives us the insights we need to work with the client to match their perspectives and feelings with the strategy that best suits them.

TRUE CLIENT-CENTERED REGRET

Our first paper set a downside regret trigger of -12% and an upside trigger of +25 percent. With that as a starting point, we identified three sets of targets with progressively lower degrees of regret tolerance and two sets of triggers that move toward the maximum regret tolerance (since these extend toward the highest and lowest values in the distribution of returns.)

We applied these six sets of “regret triggers” to the three investment strategies, and then calculated the “regret penalty” for each combination of regret tolerance and asset allocation. Our chart shows the amount of regret that accompanies each pairing of investment strategy and regret tolerance. As expected, more aggressive strategies bring on more potential regret, since their range of returns is wider than for the more conservative strategies.

We also see that a higher aversion to regret (i.e., a lower tolerance of regret) brings on higher levels of experienced regret. Conversely, a higher tolerance for regret results in a lower sense of feeling regret, and therefore a smaller regret penalty is applied.

The regret penalty is subtracted from the expected one-year return to create the client’s “regret adjusted return.”

EXAMINING REGRET-ADJUSTED RETURNS

Our three equity strategies (1/3 equity, ½ equity and 2/3 equity) earned mean returns of 7.7%, 9.0% and 10.3% respectively. We subtracted the regret penalty at each regret tolerance level to derive the set of regret-adjusted returns. After separating our clients into two groups (lower vs higher regret tolerance) we see the effect of increasing regret tolerance.

In the traditional framework of excess return and volatility risk, the move toward higher returns through heavier allocations to equity seems like a reasonable tradeoff. However, when we consider the additional risk of failing to maintain the strategy through turbulent markets is considered, the “regret penalty” takes a dramatic toll, sometimes wiping out any remaining “regret-adjusted return.” This is especially true for investors who consider themselves tolerant to longer-term, statistically-driven volatility risk, but rather fragile when it comes to the short-term emotion of regret (both for missed opportunities and unrealized losses.) We see that the highest-returning allocation (2/3 equity) produces the lowest regret-adjusted returns in five out of six regret tolerance categories. We might conclude that this aggressive strategy can only be sustained by those who can tolerate the most significant short-term uncertainty.

We also see the benefit of spreading one’s assets equally among the three diversification categories: companies, real assets, and liquid reserves (i.e., stocks, real estate/gold, and Treasury bonds.) The equally-weighted strategy (1/3 in each) produces the highest regret-adjusted returns for the “low regret tolerance” investors, and nearly-equal returns for investors with a moderate regret tolerance. While the traditional view focuses on the 130 bps return advantage between the strategies, we see that the higher volatility, and the much higher regret makes a case for “taking a lower return that you are likely to keep,” since you are more likely to maintain the asset allocation, rather than falling victim to emotionally-based trading.

If we set a minimum value for regret-adjusted returns at six percent, we establish a “green zone” that identifies the pairings of strategy and regret tolerance that produce favorable outcomes. Not surprisingly, half of the potential pairings meet the client’s risk-adjusted minimum return. Four of these are found in the most conservative strategy, three are found in the 50-50 split of equity and “reserves,” while only two are found in the aggressive portfolio that concentrates two-thirds of its assets in equity.

HOW MANY REGRETFUL YEARS CAN YOU TOLERATE?

We noted that regret comes from both ends of the return distribution; it includes both gains and losses that exceed expected limits. We examined the likelihood of these occurrences and summed them into a total regret likelihood. This is typically expressed as a percentage, but this resonates more strongly with investors when we express it in terms of years.

“How many times in a decade can you stomach feeling strong feelings of envy or despair?”

“Can you live with wishing you had done something different in one out of every five years?”

We looked at these statistics and separated out those combinations that bring out a “pit of the stomach” revulsion, and we separated them from those that seem like “Something I could live with.” It is not surprising that these pairings line up with the same choices we made when we examined the table of acceptable regret-adjusted returns.

BRINGING IT ALL TOGETHER: FOCUS ON THE DRIVERS OF RESULTS

We showed that the outsized returns that are part of every portfolio’s return volatility have an emotional component that produces feelings of regret –for decisions we made and to those we failed to make. Our analytics allow us to measure the strength of that regret by the size of these outliers and their likelihood of occurrence. Using these factors, we created a regret penalty that helps us evaluate whether a strategy is worthwhile – and this is customized to each client’s unique perspective. This is true “risk aware” investing.

The mathematics behind this methodology are straightforward, yet robust, and we apply this consistently across various strategies and individual tolerances of risk. This lets us step back and examine our results using intuitive illustrations. These charts bring together our factors and our results and present them in clear and powerful messages.

Our first illustration identifies our set of acceptable solutions. One striking insight is how these supposedly different strategies tend to converge in their results after we take regret risk into consideration.

Our second illustration groups our solutions and rank our options by our regret-adjusted returns and the likelihood of regret. The differences between our results are quite striking, and we must remind ourselves that these investment options look almost identical when we only consider traditional volatility risk!

REGRET ATTRIBUTION

Regret risk is driven by the size of the regretful returns and their likelihood of occurrence. We examine each type of regret (despair and envy) and bring together the likelihood of each across the regret triggers.

As noted earlier, the effects of regret are felt most strongly by those investors with the lowest capacity for tolerating it. As expected, the least regret-tolerant investors experience surprisingly high regret – as much as 80 percent when we combine both regret types.

The range of regret likelihood (across the six categories of regret tolerance) is also extreme: in terms of downside regret, the high range is between 18% to 24% while its lowest range is between 1% and 3 percent; and for upside regret the range is from 40% to 56% for the least tolerant clients to only 2% for the most tolerant. This provides a tangible measure of what drives the depth of emotion felt by investors.

RETURN LOST TO REGRET

As a matter of efficiency, we examine the percent of expected return that the investor retains, after taking into consideration the penalty for one’s affinity for experiencing regret. As we evaluate the ratio of regret relative to the expected return, we see a confirmation of our process for matching clients to strategies that they can sustain throughout the market’s turbulence.

Once again, we see the more conservative (and better diversified) strategies revealed as the most efficient, after considering the risk of abandoning the strategy due to feelings of regret. We see value in reaching for higher returns, while acknowledging that there may be an “inflection point” in the reach for higher returns – with regret being the singular factor that helps the investor find the point where “enough is enough” as they move along the traditional efficient frontier.

AVOIDING REGRET IMBALANCES

We observed that regret driven by envy often starts the cycle of ill-timed trades: chasing performance, then selling at a loss. The corresponding mistake is selling, only to reenter the market at higher levels. This pair of mistakes adds another aspect of uncertainty: which regret are we likely to experience next? Since this cannot be known, our only safeguard is to balance these potential regret risk. Our solutions should avoid any regret risk concentrations. Our final illustration shows the distribution of upside (envy) vs downside (despair) regret risk.

Our “regret efficient” solutions offer a reasonable balance between these sources of regret. The highest ratio of upside-vs-downside regret is about 2-to-1, where the remaining solutions have concentrations as high as six-to-one. We believe that avoiding risk concentrations is a critical component of efficiency; this may be especially true with regret risk.

OUR INSIGHTS INTO SUSTAINABLE STRATEGIES

We are more likely to achieve our investment goals if we maintain our asset allocation throughout the market’s inevitable cycles. This is easier said than done, since there is much to encourage us to abandon our strategy – either to avoid a loss or to capture an attractive opportunity. There is a preponderance of research that warns against ill-timed tactical trades driven by the emotion of regret. This is “easier said than done” but we believe that understanding the sources of regret is the first step.

Our approach to understanding regret began by understanding that it is driven by returns outside of our expectations. We developed an approach to classifying these “outlier’ returns, assigning them to both types of regret: despair (losses) and envy (gains.) Using a straightforward method to quantify these factors by size and likelihood, we created a “regret penalty” that we customized to each client’s unique tolerance for regret. This helps us match clients to sustainable strategies, using credible measures of regret that make sense.

The result? Greater confidence in understanding each client’s true tolerance for both traditional long-term volatility and short-term regret.

This has the potential to revolutionize the critical asset allocation decision, providing a robust and intuitive approach to evaluating each client’s unique perspective on risk, in the context of the market’s opportunities for investing.

.

.

.

Written in partnership with Stephen Campisi