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Regret risk and ways to manage it

By: Tom Goodwin, PhD, senior research director

“Non, je ne regrette rien!” (No, I regret nothing!), the great French chanteuse, Edith Piaf, famously sang. It was the defiant declaration of a woman who had lived through many triumphs and tragedies but never second-guessed herself. She probably didn’t do much investing, however, because investors often second-guess their choices regarding the security or fund they could have invested in but didn’t before it soared in value, or the one they did invest in that dropped like a stone.  In other words, they often have regrets. Regret is an often powerful after-the-fact, or ex-post, emotion based on results after investments have been made. In contrast, modern portfolio theory is about unemotional investment decisions made before-the-fact, or ex-ante, and has steadfastly ignored regret. But behavioral finance suggests that concern about experiencing regret tomorrow may powerfully affect investment decisions made today.  

We all fall into the habit of treating the words “risk” and “volatility” as synonymous. But volatility is only one type of risk; regret is another and is defined as the emotion experienced by an investor when an investment outcome, ex-post, is less than an alternative investment they could have easily made. It is different than disappointment, as disappointment is a negative outcome relative to prior expectations. Regret usually elicits a stronger emotional response than disappointment because there is a large element of personal responsibility for the choice that has been made. Harry Markowitz – who won a Nobel Prize as one of the fathers of modern portfolio theory – showed the power of this effect over his own personal investment choices:

“I should have computed the historical covariance of the asset classes and drawn an efficient frontier. Instead I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret, so I split my (pension scheme) contributions 50/50 between bonds and equities.”[1]

Turning to current market conditions, we have experienced an extended bull market in equities but volatility has returned dramatically, leaving many investors puzzling over what to do next. Equities suffered a 10% correction in early February before rebounding somewhat, but increased volatility remains part of the current environment. If investors miss out on further increased equity returns, they will suffer regret. Yet they will also suffer regret if they are fully in the market when there is a drawdown. What are regret risk-averse investors to do?

In some situations, there may be an answer. Take the case of foreign investments held by US investors: is it better to hedge or not to hedge the currency exposure? The investor concerned about volatility who 100% hedged his exposure to the foreign currency may experience regret.[2] If the home currency depreciates against foreign currencies – then the ex-post return of a 100% hedged portfolio will be less than it would have been if it had been unhedged. On the flip side, there is likely to be equal regret if the portfolio is completely unhedged and the home currency appreciates. Academic economists have investigated this problem and proposed a solution:[3] under the behavioral assumption that making a completely incorrect hedging decision generates more than twice the regret of making a half incorrect decision, minimum regret is found by hedging half of the foreign exposure and leaving the other half unhedged. This 50/50 solution is, of course, identical to what Dr. Markowitz intuited on his own regarding the stocks versus bonds allocation decision.

FTSE Russell research has added a couple more insights.[4] Currency movements are hard to predict and even more difficult to time. A 50/50 hedging decision is neutral with respect to the direction of the home currency because, no matter which direction the home currency goes, the half of the portfolio that got it right will roughly offset the half that got it wrong. What’s more, our research shows a 50% hedge typically reduces currency volatility by more than half of currency volatility reduction realized from a 100% hedge.   

These compelling results led FTSE Russell to recently launch five 50% hedged cap-weighted indexes that minimize regret risk while also reducing currency volatility risk: We took a closer look at the regret-reducing performance of these indexes compared to their 100% hedge and unhedged counterparts in our recent blog post “To hedge or not to hedge”.

Unlike Ms. Piaf, investors will always experience regret about some aspects of their investment outcomes. But awareness of regret risk and how it can affect decision-making gives us the ability to manage it.

For more detailed information on the FTSE Russell 50% hedged currency indexes, please read our report on currency hedging, International investment and the US dollar.

 

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[1] As quoted in Zwieg, “America’s Top Pension Fund.” Money, 1998, 27, Page 114.

[2] A 100% hedged portfolio has lower volatility than an unhedged portfolio over the long run for most markets, but it can have higher volatility in some cases, depending on the correlation between the currency and the local market.

[3] S. Michenaud and B. Solnik, 2008, “Applying Regret Theory to Investment Choices: Currency Hedging Decisions,” Journal of International Money and Finance, 27, 677-694 and G. Loomes and R. Sugden, 1982, “Regret Theory: An Alternative Theory of Rational Choice Under Uncertainty,” Economic Journal, 92, 805-894.

[4]International Investment and the US Dollar,” FTSE Russell Research, September 2017.

  

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