Kahneman (2011, p. 349) considers the biases inherent in assessing the risk of regret:
“The asymmetry in the risk of regret favors conventional and risk-averse choices. The bias appears in many contexts. Consumers who are reminded that they may feel regret as a result of their choices show an increased preference for conventional options, favoring brand names over generics. The behavior of the managers of financial funds as the year approaches its end also shows an effect of anticipated evaluation: they tend to clean up their portfolios of unconventional and otherwise questionable stocks.”
Kahneman (2011, p. 349) focuses on assessing medical assessment and playing with the risk of death:
“Even life-or-death decisions can be affected. Imagine a physician with a gravely ill patient. One treatment fits the normal standard of care; another is unusual. The physician has some reason to believe that the unconventional treatment improves the patient’s chances, but the evidence is inconclusive. The physician who prescribes the unusual treatment faces a substantial risk of regret, blame, and perhaps litigation. In hindsight, it will be easier to imagine the normal choice; the abnormal choice will be easy to undo. True, a good outcome will contribute to the reputation of the physician who dared, but the potential benefit is smaller than the potential cost because success is generally a more normal outcome than is failure.”
At this point, Morgan Housel reenters the conversation. In managing the process of assessing risk, Housel (2020, p. 116) turns to insights offered by a noted mathematician:
“Harry Markowitz won the Nobel Prize for exploring the mathematical tradeoff between risk and return. He was once asked how he invested his own money, and described his portfolio allocation in the 1950s, when his models were first developed:
‘I visualized my grief if the stock market went way up and I wasn’t in it-or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.’
Markowitz eventually changed his investment strategy, diversifying the mix. . . .
‘[M]inimizing future regret’ is hard to rationalize on paper but easy to justify in real life. A rational investor makes decisions based on numeric facts. A reasonable investor makes them in a conference room surrounded by co-workers you want to think highly of you, with a spouse you don’t want to let down, or judged against the silly but realistic competitors that are your brother-in-law, your neighbor, and your own personal doubts. Investing has a social component that’s often ignored when viewed through a strictly financial lens.”
Housel (2020, p. 142) soon offers his own insights:
“Use room for error when estimating your future returns. This is more art than science. For my own investments . . . I assume the future returns I’ll earn in my lifetime will be ½ lower than the historic average. So I save more than I would if I assumed the future will resemble the past. It’s my margin of safety. The future may be worse than ½ lower than the past, but no margin of safety offers a 100% guarantee. A one-third buffer is enough to allow me to sleep well at night. And if the future does resemble the past, I’ll be pleasantly surprised. The best way to achieve felicity is to aim low,” says Charlie Munger. Wonderful.
An important cousin of room for error is what I call optimism bias in risk-taking, or ‘Russian roulette should statistically work’ syndrome: An attachment to favorable odds when the downside is unacceptable in any circumstances.”
