Daniel Kahneman's Solution for Minimizing Investors' Regrets

News June 13, 2018 at 02:48 PM
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Daniel Kahneman. (Photo: Bloomberg) Daniel Kahneman. (Photo: Bloomberg)

Is regret-proof investing possible?

During a conversation at the Morningstar Investment Conference in Chicago, Daniel Kahneman discussed this idea with Sarah Newcomb, senior behavioral scientist at Morningstar.

The Nobel Memorial Prize-winning behavioral economist told the crowd about a period when he was working with a team that did what he described as "sort of planning, financial advising for very wealthy people."

"The idea that we had was to develop what we called a 'regret-proof policy,'" he expained. "Even when things go badly, they are not going to rush to change their mind or change and to start over," he explained.

Kahneman described this idea as "regret minimization." According to Kahneman, the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are "really not the same."

Kahneman said that this kind of "regret-proof policy" or "regret minimization" idea allows advisors to bring up "things that people may not be thinking of, including the possibility of regret, including the possibility of them wanting to change their mind, which is a bad idea generally."

In a sense, Kahneman was using loss aversion to create this measure of projected regret.

"We had people try to imagine various scenarios, in general, bad scenarios," Kahneman explained. "The question was, at what point do you think that you would want to bail out? That you would want to change your mind?"

It turns out, according to Kahneman, that most of the people — even very wealthy people — are extremely loss averse.

"There is a limit to how much money they're willing to put at risk," he said. "You ask, 'How much fortune are you willing to lose?' Quite frequently you get something on the order of 10%."

Kahneman helped come up with a solution for this, which he said is now in use at Guggenheim Partners, whom he was working at the time.

The solution is people "actually have two portfolios — one is the risky portfolio and one is a much safer portfolio," he explained. The clients decide on the allocation between them. The two portfolios are managed separately, and people get results on each of the portfolios separately.

"That was a way that we thought we could help people be comfortable with the amount of risk that they are taking," he said.

Newcomb added that this solution "seems to be a good way" to put a wall in between the money that the client wants protected and the money that the client is willing to take risks on.

"The [two portfolios] don't touch each other, and just that psychological distance between the  two allows them to feel safer even though they're in the same portfolio, really," Newcomb said.

Kahneman added that one of the portfolios will always be doing better than market — either the safer one or the risky one.

"[That] gives some people sense of accomplishment there," he said. "But mainly it's this idea of using risk to the level you're comfortable. That turns out to not be a lot, even for very wealthy people."

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