Optimizing Portfolio Allocations to Avoid Regret

Key Points:

• Risk in portfolio optimization is typically defined using volatility metrics, but this does not fully capture the range of potential outcomes or investors’ emotional responses.
• Regret, or the feeling of missing out on gains, can be an important factor to consider in portfolio allocation.
• Allocations to assets that may cause regret can vary based on individual investors’ risk tolerance and return expectations.
• A new objective function that explicitly incorporates regret into portfolio optimization has been introduced.
• Considering regret can influence allocation decisions, with risk-averse investors likely to increase risk levels and potentially achieve higher returns.
• Assets that may cause regret but are only slightly less efficient in a portfolio could receive higher allocations based on expected returns and covariances.
• Financial advisers and asset managers should consider regret in portfolio construction to help investors achieve better outcomes.
• Investors are not purely rational and need portfolios that reflect their emotions and preferences.

When it comes to portfolio optimization, risk is typically defined using volatility metrics, with a focus on downside risk or potential losses. However, this approach only captures one aspect of risk and doesn’t consider the entire distribution of potential outcomes. One important aspect of risk that is often overlooked is the emotional response investors may experience when they miss out on an investment that subsequently outperforms. This emotional response, known as regret, can have a significant impact on investment decisions.

Allocations to assets that may trigger regret can vary based on individual investors’ risk tolerance and return expectations. For example, an investor who has unfavorable return expectations for cryptocurrencies may not feel regret if the price of Bitcoin increases significantly. However, another investor with similar return expectations may have a strong adverse response to missing out on potential gains and may even abandon a diversified portfolio to invest in Bitcoin.

To incorporate regret into portfolio optimization, an objective function has been introduced that treats regret as a separate parameter from risk aversion. This function compares the portfolio’s return against the performance of one or more regret benchmarks, each with a different level of regret aversion. This approach allows for a more nuanced consideration of regret and can be applied to assets with non-normal payoffs.

Running a series of portfolio optimizations using individual securities, it has been found that considering regret can significantly influence allocation decisions. Risk levels, defined as downside risk, are likely to increase when regret is taken into account, especially for more risk-averse investors. Assets that inspire more regret tend to be more speculative in nature, and investors who are more risk tolerant may achieve lower returns with higher downside risk. On the other hand, more risk-averse investors may generate higher returns but with significantly more downside risk.

These findings have implications for different investors. Assets that are slightly less efficient but potentially more likely to cause regret may receive higher allocations based on their expected returns and covariances. This research could also influence how multi-asset funds are structured, particularly in terms of providing investors with information about a portfolio’s distinct exposures.

It is important to note that considering regret does not mean allocating to inefficient assets. Rather, it means building portfolios that explicitly take into account an investor’s preferences and the potential emotional response to different outcomes. Investors are not purely rational beings, and their portfolios should reflect this reality.

In conclusion, portfolio optimization should go beyond traditional risk metrics and incorporate regret to help investors achieve better outcomes. By understanding and accounting for the emotional aspects of investing, financial advisers and asset managers can construct portfolios that align with each investor’s preferences and goals.

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