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Risk, reward and regrets in investing: Finding the balance

Risk reward and regrets in investing

Imagine a life with all the rewards you ever wanted, but without any risk. You regret nothing because everything in your life has happened just the way you wanted. Everything!

You’ve never screwed up. You have made all the right moves in your investing journey. You’ve always invested in stocks that have shot up right after you invested and a few years later you exited it at the peak.

Most investors dream of that kind of life – no risk, no regrets, and all the rewards. But that’s not how the markets work.

Managing, not avoiding

Living life with no risk and no regrets means having the ability to see the future, analyze all the future outcomes, come back to the present and make the decision that leads to favorable outcomes. Every. Fu*king. Time.

We don’t have that ability. We have to make investment decisions based on data and experiences obtained from the past…hoping it will lead to a favorable outcome in the future.

But nobody can be certain about the future. We are at best dealing with odds and probabilities, which will not always be in our favor. We cannot fully avoid risks and regrets.

Investing is not about avoiding them altogether. It is about managing them and at best minimizing them while maximizing returns.

The whole point of managing risks, minimizing regrets, and maximizing returns is to build a portfolio that will do just fine in a wide variety of future scenarios.

If we lost a job, we have one year worth of cash in emergency savings. If we have a medical emergency, we have adequate health insurance. We have stocks in our portfolio to beat inflation and create long-term wealth. And we have a steady job or business income to ensure that we don’t become a forced seller if the markets stay low for a couple of years.

Let’s first understand what risk and regret is. I don’t need to talk about the reward.

Risk is like God – it’s invisible but always there. Risk is what we don’t see coming. We are not prepared for it. Your daughter’s higher education is not a ‘risk’ because you anticipate it and have been saving money for it.

There are all kinds of unknowns out there. And some of them are risks. The China Virus pandemic is a risk of massive proportions. Until late 2019, nobody in our modern world with all the technological and medical advancements thought that a virus would claim hundreds of thousands of lives and leave millions out of jobs.

We cannot fully eliminate risk but we can prepare ourselves to minimize its blow.

Regret is an emotion – a negative one. It rears its ugly head when we are feeling low after realizing that our present situation could have been a lot better had we acted differently in the past.

Regret arises from the hindsight bias – the tendency to believe that the past events were quite obvious but we couldn’t act accordingly. The 2008 crisis was obvious. The Dot-Com bubble was obvious. The stock you missed buying three years ago was an obvious multi-bagger, wasn’t it?

The things I regret could be completely different from the things you regret. It depends on your risk tolerance, preparedness, thought process, social status, and a bunch of other things.

But when it comes to money, some regrets seem to be common among most people. New York Life once conducted a survey of more than 2,000 people to find out the most common financial regrets. Here’s what most people regret:

  • Not starting early to save for retirement
  • Relying too much on credit card
  • Not having an adequate emergency fund
  • Not paying off the credit card balance every month
  • Taking on too much education loan

Trade-offs

So, how do we balance the risks and rewards to minimize future regrets? If only someone knew the perfect answer. We want “risk-free high returns” without ever having to regret our decisions in a wide range of future scenarios.

It all comes down to this: trade-offs. We have to make some trade-offs while handling ours life savings.

Nobody can protect their portfolio from every eventuality. If we want high returns, we have to have the appetite for high risk. A lot of investors foolishly think that they can somehow build the perfect portfolio that eliminates all kinds of risk. As I said, risk is like God. It’s always there.

The best we can do is to find out which risks are necessary, which ones we must avoid, and which risks will minimize our long-term regrets.

In every investment scenario we are making trade-offs between risk and reward…and the trade-offs are aimed at minimizing future regrets.

When we build an emergency fund, invest for retirement, reduce debt, or save for our children’s higher education, we are minimizing future regrets..little by little. Consistently.

Indexing = balancing

Some of our bets may turn out to be correct. But nobody can consistently predict which stocks are going to perform well over a specific time frame.

People will tell you that Amazon has gone up from $1.73 in 1997 to $3,000 per share in July 2020. Had you invested $10,000 in Amazon in 1997, it would have turned into $17.34 million! Imagine all the awesome things you could do with $17.34 million.

Did those people invest in Amazon in 1997 and stay invested until 2000? No. They were fu*cking scared of putting their money on the line when the Amazon stock crashed from $105 in 1999 to $6 in 2001.

The online retailer had several near-death experiences, and it could easily have gone bankrupt at any point. Barron’s predicted the demise of Amazon in 1999.

My point is, predicting the future potential of a business is hard. It requires a lot of time and energy, and your decision could still be wrong. Even if you were right about a business, it’s incredibly hard to stay invested for decades to maximize your returns.

Given the difficulty in picking the right stocks and then holding them for as long as possible, it’s far better to hold a little bit of everything by investing in a diversified index fund.

For example, the person who bought Amazon shares in 1999 at $105 sold in panic when it fell to $6 in 2001. It was one of the worst investments of his life. He would regret it for the rest of his life.

But Amazon was added to the S&P 500 index in 2005 when it was at around $40 per share. Its weightage in the index has only gone up in the last 15 years. And it has contributed to the stellar S&P 500 (and Nasdaq 100 index) returns over the last 15 years or so. The index investor never had to decide whether to hold, buy more of, or sell the Amazon stock at any point in the last 15 years. It was all taken care of by the index provider.

Investing in a diversified index fund while sticking to your stated risk profile is the best way to balance risks and rewards, and of course, minimize the future regrets.

An index investor doesn’t have to decide when is the right time to buy or sell a stock or what portion of their portfolio should be allocated to it. We just have to keep putting our money into it month after month for years or decades to hit our desired goals.

Index investors don’t get to fully participate in the biggest gains. That’s a bummer. But they don’t participate in the biggest losses either.

You get only moderate (not 10,000x) returns. But since you are meddling with your investments far less often, you are giving your money a better chance to compound over time. Be the tortoise, not the hare.

Diversification also helps control your behavior. You are not tempted to sell any one particular stock just because it has fallen 50%. Neither will you be tempted to sell when a stock nearly doubles in three months. Whether you are buying or selling, you are dealing with a whole basket of stocks instead of an individual stock.

Another reason diversification minimizes future regrets? You see, there is growth investing, value investing, dividend investing, momentum investing, quant investing, factor investing…there are a whole bunch of investing strategies. I don’t even remember all their names.

Sometimes you read that X strategy has outperformed the Y strategy…or maybe the Y strategy is dead. Those who followed the Y strategy would regret their decision. They switch to the X strategy only to see later that the Y strategy has emerged from the dead and delivered huge returns! The index investor has all those A to Z strategy stocks in their portfolio. Period.

Legendary investor Howard Marks once said that diversification involves a trade-off. You have to be happy with the ‘good enough.’ Sure, you would be missing out on the biggest gains but you’ll also be avoiding terrible losses.

“Here is part of the trade-off with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term”

Howard Marks

One thing I like the most about diversification is that I can sleep peacefully at night, knowing that even if a company’s management pulls some shady sh*t and the stock goes bust overnight, it would have very little impact on my portfolio. Fewer regrets.

The behavioral side of things

Wealth isn’t primarily determined by investment performance, but by investor behavior.”

Nick Murray

Every expert (I’m no expert) says our emotions, our behavior have a huge impact on our long-term returns. Managing our emotions – including how we perceive risks and potential regrets – can make us insanely wealthy or…

We think we understand our own behavior and risk appetite, but we don’t. At least not until we have lived through a crisis and a bull run both.

At what point will you start panicking?

Noted behavioral psychologist Daniel Kahneman once said that we are “extremely risk averse.” Even the super-rich start losing their stomach when their net worth drops more than 10-20% during a financial crisis.

We have to find how risk averse we are to determine our portfolio allocation. The stock markets fell as much as 50% during the 2008 recession and about 30% during the 2020 crisis (so far). What kinds of volatility can you stomach?

Ask yourself, if the stock market fell 30% and stayed down for five years, how will it affect your life? Now you know how much to invest in stocks and how much to invest in bonds and other assets. And now you’d probably want to build a bigger emergency corpus first, depending on how secure your income source is.

Our future returns will depend more on how we behave than how our investments do.

The imprint of a recent event

We become more risk averse after witnessing an economic crisis. The Wall Street Journal columnist Jason Zweig calls it the “Jaws syndrome.” After Steven Spielberg’s movie Jaws hit the theaters in 1975, people in America were scared of going to the beaches even though there had been only 66 shark attacks in the preceding 10 years.

After watching the movie, tens of millions of people were terrified that they could be the next victim of a shark attack! Unfortunately, the sharks never got to watch the movie. They had no clue how the things that appeared on theater screens changed the behavior of the weird creatures living on the land.

There is a strong historical evidence that stocks have far outperformed other asset classes in the long run. But after living through an economic crisis, investors tend to shun stocks and hoard cash, bonds, gold, and real estate. Fast forward from 1975 to 2000, did Americans keep avoiding the beaches in 2000?

The ‘near-miss’

What’s the one thing investors regret as much as, if not more than, losing money? It’s when they make an investing mistake and have to look in the mirror, “How could I be that stupid?”

Let’s say you and I have ₹100 each. You purchased one share of Stock A trading at ₹100 and I bought a share of Stock B at the same price.

After a year, my Stock B is trading at ₹110 and your Stock A is at ₹107. You decide that Vik’s B is a better buy than your A. So you switch to B.

After another year, B is worth ₹120 while A has jumped to ₹145. Now, I’ll be happy that my B stock has gone up from ₹100 to ₹120. But you will kick yourself for switching from A to B and missing out on A’s stupendous gains. You’ll regret switching from A to B.

Why does this happen? It’s the regret of a “near miss.” Daniel Kahneman says “People become more frustrated in a situation where a more desirable alternative is easy to imagine.”

Psychologists have found that Silver medalists in Olympics regret more than Bronze medalists. Silver winners “just missed” winning the Gold while Bronze medalists are happy that they won a medal. The perspective matters.

Index investing is not good for your ego

Most investors don’t invest in index funds because of two reasons. One, it’s far too simple and boring. You don’t get to put all your knowledge and skills about valuation models, investing strategies, fundamental analysis, etc. into your investments.

Without actively using these things, what are you going to tell yourself and others? That you invest in those boring index funds? That you are not a value investor / growth investor / microcap investor / technology investor / momentum investor / quant investor, etc.? How will you make your Twitter bio shine?

It’s not a sign of intelligence to tell people that you are an index investor. No, index funds are not good for your ego.

The second reason is that we always have this craving to perform better than others. If we invest in index funds, we are just going to get ‘average’ returns. Same as everyone else. Index investing eliminates any chance of outperforming the market. It just mimics the market.

Most of us don’t want to settle for the average. So, we look to active funds to beat the market. Our focus shifts from meeting our financial goals to beating the index!

Unfortunately, it’s incredibly difficult to find an active fund manager who has consistently outperformed the broader market. Even more unfortunate is the fact that most active fund managers struggle to beat the index, thanks to their ridiculously high fees.

The behavioral gap

If you get only ‘average’ returns from an index fund but let your money compound over a long period of time without interfering with it, you are going to do better than most investors out there. Easy peasy.

Most investors have this temptation to get in and out of the market, which hurts their long-term returns. Plan your investments based on your goals to avoid interrupting compounding unnecessarily.

study conducted by Axis Mutual Fund found that investors get much lower returns than the corresponding fund returns. Between 2003 and 2019, equity mutual funds delivered an 18.8% CAGR but investor returns were much lower at just 12.5%. This 6.2% gap between fund and investor returns led to investors getting 2.5x less than what they could have.

The huge gap between the fund and investor returns can mainly be attributed to one thing: investor behavior.

Of course, investors will have to sell some of their holdings from time to time for children’s education, buying a house, etc. But Axis Mutual Fund noted that investors overreact to the recent market trends and sentiments. They chase the latest top performer.

It’s more important to stay invested through thick and thin because much of the market gains come only in a short period of time. And if you stay out of the market on those few days, you will get to see for yourself the gap between your returns and fund returns.

God! Too much of rambling. I need to stop now.

About the author

Vikas Shukla

Vikas Shukla

Vikas is Insider Paper's Editor/Writer. He has been covering the latest developments in Tech and Politics for about a decade. He loves trekking, playing chess, and reading. - Email: copywritershukla@gmail.com




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