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Investing With No Regrets

Many of our clients are considerably more aware of market risk now than they were a year or two ago. However, while volatility and day to day fluctuations of the market may alarm you, you may still fail to capture the true measure of financial risk, argues York University Professor Moshe Milevsky. Milevsky believes that risk should be framed and explained in terms of “the probability of regret”. In other words, the odds that cautious investors might be able to do better if they opt for a safe, risk free investment like T-Bills.

Imagine that you have received a windfall inheritance and are waffling between buying a well-diversified equity fund or putting it all into GIC’s. If you take the plunge and invest it all in the equities market, what are the odds that you will regret the decision?

Over a one-year time horizon, there is a 35% chance that a diversified portfolio of equities will under perform the rate of return from the safe bank deposit, Milevsky reports. Consequently, if you where going to need the money in one year, there’s a 35% chance that you will regret making the equity based investment.

But what if you don’t need the money for 10 years? In that case the probability that the diversified portfolio of equities will have a shortfall falls to only 11%. Remember, you are not just content with the return of principle. The regret benchmark measured by Prof. Milevsky is much higher, you want to beat the risk-free investment alternative, which is the bank deposit.

Obviously, the important lesson is that as the investment time horizon increases, the probability of regret decreases exponentially. Where does it all end. The probability of financial regret is close to 1% as the time horizon extends to 30 years – less than most people’s working lives and as long as many people are retired.

Despite this, many investors still choose certainty (“somewhere down the road, I’m going to get my money back no matter what”) when what they really want is safety (“even though everything will cost three times as much in the future, my increased wealth will still let me buy what I do today”) and that can be a very costly choice.

As much as they should be, investor’s financial decisions are generally not made based on the final outcome of an investment plan. Instead, most people – psychologists refer to this as narrow framing – think in terms of the more immediate gains and losses attached to a particular investment decision. As a result many people make the wrong decision when trying to build or maintain wealth over the long term.

While nothing in this world is certain, we can make decisions with the probability of success in our favour. As your financial consultants we will continue to ensure that you don’t confuse short-term volatility with financial risk. As we have seen time and time again, financial risk has an embedded dimension of time. It is meaningless to discuss risk without talking about an appropriate time horizon over which you are planning.

If you would like to learn more, much of this information was taken from Professor Moshe Milevsky book titled “Money Logic” which we have in the office.

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