Close Close
ThinkAdvisor
David Blanchett

Portfolio > Portfolio Construction > Investment Strategies

The Potential Case for FOMO Investing

By David Blanchett

X
Your article was successfully shared with the contacts you provided.

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.

To be clear, not all investors are going to experience regret (or FOMO), and even those who are likely to, do so for different assets and at different levels. Traditional portfolio optimization routines ignore regret and, I think, can leave investors exposed to trend chasing.

Keeping the Grass Growing

Good investing is often described in relatively boring terms, such as comparing it to watching grass. While I don’t disagree with this perspective, the ability of individuals to watch grass grow is going to vary. Some investors are perfectly content with owning a diversified portfolio for the long term and are immune from the latest craze. Other investors, though, may exhibit significant behavioral tendencies that could potentially derail a period of otherwise smart investment decisions.

I think the key to dealing with regret is not simply ignoring it (eat more broccoli!) but rather attempting to understand how it may potentially affect an investor, especially over the long term. I think the best way to deal with this is to allow an investor to allocate some portion of total savings — ideally as little as possible! — to invest in those things the investor is passionate about.

While someone may suggest allocating some portion of financial assets to (highly) speculative assets would reduce long-term wealth, this isn’t necessarily the case given the emotional considerations with accumulating wealth. Saving money earmarked for retirement that is invested in a professionally managed portfolio may not excite an investor and to some extent could discourage savings.

On the other hand, creating a separate account specifically targeted toward investments that are more speculative in nature (bitcoin!) could actually result in higher savings rates as well as the desire to learn more about investing. The key is owning enough of a given speculative asset to satiate concerns about regret while letting the remainder of the portfolio grow.

Regret Affects Us All

Even the father of modern portfolio theory, Harry Markowitz, acknowledged the role of regret when building a portfolio during an interview with Jason Zweig. When asked how he diversified his portfolio, he stated, “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.”

While Markowitz would go on to further diversify his portfolio, his comment provides important context on the implications of regret when building a portfolio. Ignoring regret doesn’t mean clients don’t experience it, and if the person who created the framework used to build portfolios allowed regret to affect his portfolio, it probably means regret is at least worth considering when building portfolios for your clients!

David Blanchett is managing director and head of retirement research for PGIM DC solutions.

David Blanchett

NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.