Tuesday, May 23, 2006

Anticipate "regret" in your investing, and you'll do better

I've now finished a decent book relating to risk management, Upside Downside: Simple Rules of Risk Management for the Smart Investor. It's a light read and a rather small book - nevertheless, it has some good ideas.

The book makes the point that we need to take more into consideration than just the risk of the investment (or risk of an insufficient return). We need to consider our emotional make up and how we react to a potential loss (or lack of what we consider a sufficient return). The book uses the apparently true life example of a 32 Englishman who sold everything, went to Vegas and bet his entire life savings ($135,000) on the spin of the roulette wheel. Having doubled his money, he left the table and returned to his homeland.

The book points out that although this is a poor investment (odds are less than 50% of doubling your money, due to "00"), he probably considered how much regret he'd have if he never took this chance, against the potential to double his money. His regret would obviously be quite different than a 75 year old betting a similar life savings.

So in addition to considering the actual risk/reward profile of the investment, we need to consider how we feel about each of the possibilities - then to decide whether to invest, based investing an amount that won't exceed the maximum amount of regret we can handle. For some people, regret is the possibility of missing the next Microsoft, while for most investors it involves a perceived loss of capital. Some studies have suggested that the average investor experiences regret at a 2:1 ratio. That is, a loss of 10% produces about twice the regret that a gain of 10% produces happiness.

The main point is, is that if we structure our investments to reduce the possibility of regret, we'll stay in the market longer and increase our chances of long-term success.

All-in-all, a useful book, but it has some limitations, that I'll talk about in a final review, later.


The Confused Capitalist

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