Tracking Error Regret & Emotional Bias

Tracking error regret is a by-product of concentrated investing risk exposure & can make investors emotionally biased & feel angry or frustrated. Read here....
David Roberts
September 10, 2021
Home » Behavior » Tracking Error Regret & Emotional Bias

When it comes to investing and preparing for retirement, everyone wants to “win” by making smart decisions with their money. In any given moment, what we call a “smart decision” will be what feels like the most sensible thing for us to do based on our circumstances and the situation at hand. Yet, all too often, how we decide upon what is “most sensible” will come by examining our circumstances and situation through the emotionally filtered lens of our thoughts, feelings, and beliefs. Behavioral science has shown us that Retirement planning this approach can leave us more susceptible to mental errors as we’re assessing and processing information, even jumping to false conclusions, and causing mistakes which often lead to results opposite of what we want to accomplish.

This is particularly troublesome for us when some other benchmark outperforms our wisely designed and globally diversified portfolio. There’s never a problem when our portfolio outperforms the benchmark – we’ll naturally say that’s the result of a smart decision. But it can be an uncomfortable feeling knowing that we just missed out on gains that should have been ours. This feeling leads to regret that will emphasize our error: we should have known to put our assets in that other basket and “won” like so many others.

Tracking Error Regret

The technical term for this feeling is called tracking error regret. Tracking error occurs whenever a portfolio of invested assets is not capturing the same returns as a popular benchmark like the S&P 500. Regret over tracking error is a psychological risk that investors need to be aware of because it’s very hard for our emotions to reconcile the underperformance of our portfolio when compared to the performance of a benchmark, even when we know our portfolio was designed with the prudent, long-term strategy of global diversification and specific factor tilts.

Tracking error regret can become infuriating at times, especially when the talking heads of the financial news media are telling us what’s about to happen in the markets and reminding us that we’re losing with our money when we could be winning. We are human, and our brains are not wired to accept uncertainty. The markets are confusing, and what these pundits are predicting makes sense and seems to be backed with logic and sound reasoning. We would be foolish not to take their advice. All the careful and prudent planning that went into building a globally diversified portfolio is now taking a backseat to our regret and to the prognostications of financial entertainers who claim to have specific knowledge about the future.

Fortunately, nearly everyone agrees that diversification is a wise and prudent investment strategy, and you’ve done well if you have taken care to choose your mutual funds, ETFs, and other assets accordingly. But now the reality is setting in that this feeling of regret is not going away, it is not very pleasant, and you are increasingly tempted to do something that will help you feel better.

There is a psychological misdirection going on as your emotions are screaming “you’re losing!” when it’s clear that others are “winning.”

It’s just plain wrong that anyone should feel that this is what’s really happening, because Modern Portfolio Theory shows us how we can construct a diversified portfolio that helps us achieve the expected, long-term returns we need with less overall underperformance and volatility. In short, the odds will be in our favor that we will “win” with our money and accomplish our financial goals, while staying within our comfort level with risk and volatility – a very smart decision.

Sadly, our emotional biases and impatience are at play and can lead all but the most disciplined investors to abandon their well thought out investment strategy for the “shiny object” getting all the attention from the financial news gurus.

Relativism

I pointed out how tracking error regret can be infuriating, and an emotional bias called relativism is one of the culprits of our frustration. The relative performance of our portfolio with respect to a given benchmark often influences our happiness, satisfaction, and our discipline sticking to an investment strategy. It can be described as wisdom and experience losing the battle with our emotions. This is ironic when you consider that the history of the financial markets shows us that anything going on today is merely “noise” in the long-term context.

Your diversified portfolio should never be compared to an index like the S&P 500, since that benchmark in particular represents large, US companies – it’s not an apples-apples comparison. If your portfolio did have a strong correlation to the S&P 500 – or any other popular benchmark – it wouldn’t be diversified.

Recency

Recency is another emotional bias contributing to tracking error regret and can be described as mentally projecting current market performance into the future and basing your investment strategy accordingly. As stated earlier, what is going on in the markets at any given moment is simply “noise” in the context of the market’s long history. And we humans are susceptible to favoring current events over historic ones as we plan for our future. Many investors will see the last 10 years of strong performance by US large companies as a bellwether and adjust their portfolios accordingly. They won’t even consider that the preceding decade – 2000 to 2009 – was one of the worst performing decades in the history of the S&P 500. And predicting the next decade will see continuing overperformance might be as tragic as those 2009 predictions of continuing underperformance.

Recency can also lead to behaviors which contradict the age-old advice, “buy low and sell high.” When we notice a stock, fund or ETF that has been performing well, we naturally want to buy it and win if we think it will continue to outperform. Similarly, when investments we own are underperforming, we’ll cut our losers if we think they will continue to underperform, dragging down the returns of our winners. But the sad thing is that no one can predict what results will “continue” in their portfolio and thinking they can will cause many retail and professional investors to underperform the market year after year.

Impatience

Impatience also contributes to tracking error regret. For many investors, 3 to 5 years is long-term, and 10 years seems like forever. And it’s this misperception of what constitutes a meaningful time-period in financial market history that will cause many to prematurely abandon their investment strategy for fear that the underperformance they’re currently experiencing will end up causing them to “lose” with their money.

A characteristic of the impatient investor is letting their fear and emotions rule their decision-making. As humans, we are not born patient – we are designed to react to threats. So, when we react to negative circumstances and changes in our portfolio, we feel as if we are making smart decisions with our money. But abandoning a prudent, diversified investment strategy is certainly not a smart decision and may lead to the very underperformance we’re trying to avoid.

“In the end, how your investments behave is much less important than how you behave.” — Benjamin Graham

Closing Remarks

Retirement planning involves building your portfolio in a way which gives you the highest probability of “winning” with your money and which is based on your goals and comfort level with risk and volatility. Therefore, a more appropriate measure of the long-term success of your retirement plan is how much progress is being made toward accomplishing your goals – not the portfolio’s performance relative to any given benchmark.

I know you want to feel more confident about your chances of success, and I am committed to being with you every step of this journey, helping you to make it as successful as it can be. I hope this information has been helpful, and I am happy to answer more questions or to help you design a financial plan that will give you the confidence about the future you want. Working with me is easy

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