Acts of Commission make you feel worse than Acts of Omission

Take a look at this 5 min video about Dollar Cost Averaging by Professor Kenneth French.

Dollar (UK investors should read Pound) Cost Averaging, in this case refers to lump sums available for  investment which, instead of  immediately being fully invested in the markets, are allocated over a series of months. The objective is to avoid being caught out by sudden market falls shortly after making the investment. In the UK we call this ‘Phased Investment’.

Interestingly, Prof French  reinforces the academically accepted view that Dollar Cost Averaging does not optimise returns, given the level of risk that an investor wishes to take. When considered purely from a finance perspective, if the right thing to do, in order to deliver a set of goals, is to invest in an equity portfolio, then it should be implemented in full, immediately. Market timing has been shown to contribute very little to returns and as a consequence there is no good reason to delay.

But, is this always right? Well ,Prof French observed that, from a behavioural finance point of view, it may be a good thing. People apparently feel worse about the negative outcomes from acts of comission (things they did) than they do about acts of ommission (things they didn’t do). Hence an investor feels a lot worse about the fact that his portfolio plummeted shortly after investing the money that he does about the returns which he failed to make because he didn’t invest the money.

On balance, Prof French concludes that, even with his finance professor’s hat on, the damage to prospective returns caused by Dollar Cost Averaging is very little, so it makes little difference whether investors use it or not. However, he observed that it may give them an experience that they feel better about.

Ultimately as investment professionals and, especially as financial planners, we do need to step outside of the theoretical world of optimised portfolios and look at things more closely from our client’s point of view. If doing things that are theoretically sub-optimal but not actually damaging makes our clients feel better about what they are doing then there is no good reason not to facilitate this. After all we are not on some kind of Evangelical mission to convert the pagan unwashed. Oh, and it is their money…. not ours.

Interesting huh!

2 comments on “Acts of Commission make you feel worse than Acts of Omission

  1. apes on

    Pretty cool post. I just stumbled upon your site and wanted to say that I’ve really liked browsing your blog posts.

    Anyway, I’ll be subscribing to your feed and I hope you write again soon!

    Reply
  2. anthony wicks on

    Agree with what Chris said, as Head of Asset and Liability Management of one of the largest banking groups in Italy (record profits year after year and over budget this year) amongst other titles, alot of what I do has scientific method, about 20% is a “guess” at where the future is/might be, having to look after about € 50 bln in Assets and Liabilities I have to have some luck too. I also give informal advice to “the wealthy”, here I again I agree with Chris, theory brings you to the water, then you have to convince the client or give him market realistic options with the respective pros and cons. Pure thoery is just for the classroom, it has no place in operational finance as the sole means of making a decision, or most of the professionals would be out of a job if it were that simple.

    Reply

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