Lothian’s Law: rationalise your regret

By on

If the psychology of fear and greed drives the markets, then it’s the emotions of hope and regret which permeate fund selection.

Fund investing has an additional layer of hope and regret on top of that experienced by direct investors. Any investment is a bet on an uncertain future; fund investment is a bet on how someone else will deal with that uncertain future. Fund selectors try to align their hopes and potential regrets with the fund managers they invest with, introducing a further dimension to the problem.

A far smarter man than me once said that in allocating to an active fund, the investor is buying hope. We all know that hope alone is a dangerous investment strategy and so this gets tempered by regret, or rather the fear of future regret. Given what we know about the average after-fee results of active funds, this ‘regret risk’ is a real issue and indeed is one of the biggest drivers of the recent growth in index-tracking funds and ETFs.

Types of hope

How we handle our hopes and manage our regrets manifests itself in our choices and reactions. Let’s deal with hope first – it’s easier. There are two basic forms:

  1. I hope that X happens
  2. I hope that X doesn’t happen

Although the prevailing doubt can never be alchemised into certainty, we look to justify our hopefulness (or educate our bravery) through research. If we’re confident that our research is thorough and of good quality, then we should understand the possibility of regret and be better able to rationalise it if needed. In forward-looking fundamental fund research, we generally judge process, with the assumption that this is a proxy for future outcome. There will still be variability – bad results can come from good processes and bad processes can give good results.

Types of regret

Regret is when hope goes wrong: I had hoped that X wouldn’t happen but it did; I had hoped that X would happen, but it didn’t. We can therefore regret things we did or regret not doing the things we didn’t. In short, regret can be ‘oops’ or can be ‘d’oh’.

General regret Fund selection example
I did X and now wish I hadn’t Picked fund A but it underperformed
I didn’t do X and now wish I had Didn’t exit fund B, and it crashed
I did X but shouldn’t have, but somehow got away with it Picked fund C based on a flawed assumption, but it outperformed anyway

The third type of regret is very rare in our industry, due to retrospective adjustment of past rationale. Most of us are Machiavellian enough to think that if our selected fund outperformed then there’s no need to regret the fact that the source of outperformance was a surprise to us. When looking back, we attribute overly-high probabilities to the events which we now know happened. We tend not to attribute a lot of our success to good luck.

Dealing well with regret risk is similar to how we bolster our hope – a lot of it comes down to trusting in your research, and trusting yourself.

The big questions about managing regret
Retrospective risk Should we look back and ask what might have happened? (or is that a waste of time now that it’s all in the past?)
Potential regret How can we steel ourselves to accepting risks and living without regret, even if our downside materialises?
Path dependency Does the destination justify the route? Is it only a success if it succeeds the way you intended/thought it would?

Fund selection is a world of analysing the actual and expected. It’s easy to rationalise past expectations and/or lose sight of what we had previously reasonably expected. If we don’t document thinking at the time, history will have a way of writing itself, and we won’t learn much. Once we know that X happened, should we revisit how likely this outcome was in the first place?

In my career, several of the more successful decisions were to exit funds after seeing evidence of process breakdown, even when performance had been good. On the flip side, many of my ‘Type 2’ regrets are about seeing process or team breakdown and not exiting the fund.

That’s not to say I haven’t felt that some of my selected managers have been very lucky from time to time – they certainly have, and I have suggested as much to them. ‘All that great performance last year, Jimmy – that was pretty lucky, right?’ – you can imagine how popular that made me!

Taking the easy route

Many selectors aim (consciously or otherwise) to reduce regret risk by taking the easy or popular option – the fallacy of safety in numbers. Being orthodox implies less regret risk. Being wrong alone is a very difficult situation, in career and psychological terms. But running with the crowd reduces the upside, as is well documented.

So what can fund selectors do today to minimise tomorrow’s regret without reducing risk (and hence the scope of anticipated good results)? My best advice is to be aware of realistic outcomes. Codify managers’ results in order to minimise the amount of regret you feel, ie you should not feel so bad about an outcome outside of reasonable expectations.

In my time at BEA Union in Hong Kong, we devised a system for monitoring performance observed compared to what we expected, and raised flags when these diverged significantly and persistently. This also helped to identify a breakdown in process, or more commonly if we had evidently misunderstood the process. It was ex-post – but late is better than never.

I leave you with some final thoughts, which can be borne in mind when we are feeling regret: we naturally learn from our mistakes, and experience is what we gain when we don’t get what we want. American pop singer Kelly Clarkson put it best: what doesn’t kill you makes you stronger.

This is my last article in the series – many thanks for reading – here’s hoping I don’t regret anything I’ve written here!

Scott Lothian has held senior roles within both consulting and fund selection. He has now joined Schroders as a senior strategist on its Global Strategic Solutions in London.