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May 08, 2023 at 03:54 PM
What You Need to Know
- Financial advisors have commonly ignored clients' emotional impulses when building portfolios.
- Portfolios built with a dash of FOMO may appear less efficient but may help investors achieve better outcomes.
- The key is owning enough of a speculative asset to satiate concerns about regret while letting the remainder of the portfolio grow.
The “fear of missing out,” or FOMO, is an emotion that is commonly ignored when building portfolios for clients. People are not all utility-maximizing robots, though, and explicitly considering FOMO (or regret) when building portfolios for clients has the potential to improve outcomes, especially since investors abandon well-diversified portfolios when certain assets, especially speculative assets, have significant positive return.
In this article, I summarize the implications of some new research I just published in The Journal of Portfolio Management focusing on how regret can affect optimal portfolio allocations. Overall, I think financial advisors need to more proactively consider regret when building client portfolios.
While the portfolios may appear less efficient from a more traditional expected risk-adjusted return perspective, these portfolios may actually help investors accomplish better outcomes for a variety of reasons.
The FOMO Struggle Is Real
Households are especially prone to trend changing when it comes to investing. There have been countless bubbles that have occurred over time, whether relatively recently (e.g., the tech bubble, the real estate bubble) or even going way back (e.g., tulips!) where the runup in the price of some relatively speculative asset results in investors abandoning relatively well-diversified portfolios with the hopes of cashing in on some new craze.
Regret can be best characterized colloquially in the concept of FOMO, which is the “fear of missing out.” In scientific literature, the term FOMO is generally defined as the apprehension that others are having rewarding experiences from which one is absent and the persistent desire to stay connected with people in one’s social network.
The first aspect is related to cognitive anxiety (for example, worry, rumination, etc.), while the latter component involves a behavioral strategy aimed at relieving such anxiety. The way households receive information about investments has changed recently, especially given the rise of social media platforms, making FOMO an increasing “threat” to investors with respect to maintaining a diversified portfolio.
Cryptocurrencies would be an example of an asset that has evoked different emotions among investors recently. Since I’m not really a fan of cryptocurrencies from an investment perspective, and I’m a relatively rational investor, a significant increase in the value wouldn’t really affect me that much from an emotional perspective.
In contrast, another investor with identical return expectations (not good) may respond very differently to a potential runup in price and therefore may benefit from at least a small allocation. While including bitcoin in a portfolio would reduce the risk-adjusted returns (using my return expectations), it could have the opposite effect if bitcoin does well.
