Intelligent Investor: Graham Witcomb has no regrets

Being honest about your personal flaws will allow you to build a portfolio you can live with

There are two ways that forecasting is useful in investing. The first is in making successful predictions about an industry or a specific company’s outlook. The second is in making honest predictions about yourself. A 2015 study found that over the previous 20 years, the average US mutual fund investor earned a return of 4.7% compared with the market return of 8.2% – a gap of 3.5%. Almost half the underperformance was due to “voluntary investor behaviour” – panic selling, exuberant buying and trying to time the market.

“No evidence has been found to link predictably poor investment recommendations to investor underperformance,” the researchers said. “Analysis of the underperformance shows that investor behaviour is the number one cause, with fees being the second leading cause.”

Psychologist Daniel Kahneman has said that “regret is probably the greatest enemy of good decision making

in personal finance”. Kahneman won the Nobel Prize for his work on “prospect theory”, a descendent of which is “regret theory” – that our fear of regret (ie, losses) is felt more strongly than the anticipation of gains. We tend to overestimate how much regret a decision could lead to, which biases our choices.

When the market is down, anticipated regret can prompt you to panic-sell at the bottom. When things are going well, a fear of missing out might encourage you to buy at excessive valuations or put too much of your money at stake.

Anticipated regret is also why we tend to focus on sunk costs, rather than make each new decision on its own merit. If a stock has been doing well for us, we tend to shop around less for the next bargain, preferring to stand by our earlier commitment.

And when a stock is doing poorly, we hold on for dear life or even double down. We justify our continued investment not despite prior losses, but because of prior losses. We hate the idea of letting go and having nothing to show for our ordeal, even if we recognise our original investment case was flawed.

Knowing where you sit on the regret spectrum is the first step to improving your decisions. You should get a sense by answering the questions below, which are part of the Regret Scale, a tool commonly used by psychologists.

Intelligent Investor is big on reducing risk: we use recommended portfolio weightings, risk ratings and price guides, all of which are there to reduce your risk of loss. Let’s put risk minimisation aside for a moment, though, and focus on regret minimisation.

1. Split your portfolio

Regrets are a product of prior decisions – usually those that led to a loss or a missed opportunity. If you want to build a regret-proof portfolio, Kahneman suggests splitting it in two: one managed conservatively, to avoid loss, and another managed aggressively, to pursue opportunities.

In the conservative portfolio, you own a mix of fixedinterest investments and low-cost, highly diversified index and managed funds. And you hold them for the long term – the less fiddling the better. By leaving these investments to professionals or algorithms to manage – and maintaining a cushion of safe assets, like cash – you create emotional distance and a sense of resilience.

Your aggressive portfolio, on the other hand, is built to satisfy your fear of missing out. Here you stay 100% invested in stocks, and you’re free to concentrate your positions more, pick individual companies and take larger doses of risk.

How much you allocate to each portfolio will depend on your personal tolerance for risk. Whatever your allocation, the important thing is to put on a different “management hat” for each portfolio, and never mix hats. You measure your results separately and keep any income siloed. Once you add funds to one of the portfolios, you never withdraw it to prop up the other.

By splitting your portfolio into conservative and aggressive parts, one will always be doing better than the other. During panics, you can sleep easy knowing a safety net is there to see you through, while in boom times your aggressive mix offers the prospect of above-average returns and some “play money”.

A split portfolio may not completely remove regret, but it will mean there’s always something to be thankful for. That should dull your urge to make hasty changes.

2. Ulysses contracts

We’re big fans of what psychologists call Ulysses contracts – locking yourself into a favourable outcome by intentionally removing your options.

Consider setting up your conservative and aggressive portfolios at two different brokers – and, dare I say it, specifically choose a broker with high trading commissions or a clunky user interface for your conservative portfolio. It may seem inconvenient, but that’s the point – it discourages activity.

We also recommend putting your investments on autopilot wherever possible. Participating in dividend reinvestment plans is one way, and many funds offer the option to automatically reinvest distributions or make regular contributions.

You can build Ulysses contracts into your savings, too: check if your bank account offers a “sweep” function, which will isolate a certain amount of your pay each month and deposit it to an investment account. From there, you can use dollar cost averaging to avoid over-investing or under-investing during emotional times by committing to a certain amount at predetermined intervals.

No portfolio is ever truly regret-proof. However, by splitting it in two, using Ulysses contracts and investing part of your savings in hard-to-reach places, you can both ease your nerves and make it tougher to act on them.

Ultimately, the best strategy to avoid regrets may be recalling a simple truth: no one on their death bed looks back and regrets selling XYZ too soon or not buying enough of ABC. If it doesn’t matter then, don’t beat yourself up about it now.

There’s more to life than investing. Let go of what you can’t control, remember that mistakes are opportunities to learn, and take a moment to reflect on all the things going right.