What Is Omission Bias?

Omission Bias is the tendency to think it is better to do nothing than to do something and make
a mistake. We all have this tendency because it is a fundamental part of our psychology. It can be
particularly strong when thinking about how much we will regret something in future if we make a
mistake. We think we will regret doing nothing less than we will regret doing something.

This matters in financial markets, because it is not necessarily better to do nothing than to do
something. The tendency to inaction creates inertia. We hold on to stocks longer than we should. We
fail to buy new stocks when we should also do that. Formally, this is because is no practical difference
between the following two scenarios. I could invest $100 in a stock that declines 10% the next day. I
could also fail to buy one stock that appreciates 10% the next day. In both scenarios, I have lost $10. But
Omission Bias will make me think that scenario two is better than scenario one. This is because in
scenario two I have done nothing while in scenario one I have done something.

In this way, our psychology makes us prefer to do nothing. But the only important metric to
judge the quality of my trading is the financial result. And that was the same in both scenarios: I do not
have $10 that I would have had.

Where it occurs

Imagine the following scenario.

You are on a walk when you see a runaway trolley car barreling down the railroad tracks. A group of five
people are in the path of the trolley, and are unable to move out of the way in time to escape. You see
there is a lever close to you that can switch the direction of the trolley onto another set of tracks.
However, you notice one man standing on the other tracks that would also be unable to escape if you
pulled the lever.

You find yourself in a moral dilemma with two options. You can A) do nothing and have the trolley kill
five people or B) pull the lever and kill one person in order to save five. What is the right thing to do?

While neither option is optimal, most people would agree that option B is the most morally sound.
However, you might feel like the action of pulling the lever and killing one person would instill more guilt
than the inaction resulting in the death of five people. Even though the consequences of choosing
option A are worse, our desire to abstain from any harmful actions (and the subsequent blame) can
override the more ethical choice. This famous thought experiment, dubbed “the Trolley Problem”,
demonstrates the omission bias in action.

What Is Regret Theory?

Regret theory states that people anticipate regret if they make the wrong choice, and they
consider this anticipation when making decisions. Fear of regret can play a significant role in dissuading
someone from taking action or motivating a person to take action. Regret theory can impact an
investor's rational behavior, impairing their ability to make investment decisions that would benefit
them as opposed to harming them.
KEY TAKEAWAYS

 Regret theory refers to human behavior regarding the fear of regret, which stems from people
anticipating regret if they make the wrong choice.
 This fear can affect a person's rational behavior, impairing their ability to make decisions that
would benefit them as opposed to those that would harm them.
 Regret theory impacts investors because it can either cause them to be unnecessarily risk-averse
or it can motivate them to take risks they shouldn't take.
 During extended bull markets, regret theory causes some investors to continue to invest heavily,
ignoring signs of an impending crash.

By automating the investment process, investors can reduce their fear of regret from making incorrect
investment decisions.

Understanding Regret Theory

When investing, regret theory can either make investors risk-averse, or it can motivate them to
take higher risks. For example, suppose that an investor buys stock in a small growth company based
only on a friend's recommendation. After six months, the stock falls to 50% of the purchase price, so the
investor sells the stock and realizes a loss. To avoid this regret in the future, the investor could ask
questions and research any stocks that the friend recommends. Or, the investor could decide to never
take seriously any investment recommendation made by this friend, regardless of the
investment fundamentals.

Conversely, suppose the investor didn't take the friend's recommendation to buy the
stock, and the price increased by 50%. To avoid the regret of missing out, the investor could become less
risk-averse and might likely buy any stocks that this friend recommends in the future without conducting
any background research.

Regret Theory and Psychology

Investors can minimize the anticipation of regret influencing their investment decisions if they
have an understanding and an awareness of the psychology of regret theory. Investors need to look at
how regret has affected their investment decisions in the past and take that into account when
considering a new opportunity.

For example, an investor may have missed a large trending move and has subsequently only
traded momentum stocks to try to catch the next significant move. The investor should realize that
he tends to regret missed opportunities and consider that before deciding to invest in the next trending
stock.

Regret Theory and Market Crashes

In investing, regret theory and the fear of missing out (often abbreviated as "FOMO") frequently
go hand in hand. This is particularly evident during times of extended bull markets when the prices of
financial securities rise and investor optimism remains high. The fear of missing out on an opportunity to
earn profits can drive even the most conservative and risk-averse investor to ignore warning signs of an
impending crash.

Irrational exuberance—a phrase famously used by former Federal Reserve Chair Alan Greenspan
—refers to this excessive investor enthusiasm that pushes asset prices higher than can be justified by
the asset's underlying fundamentals. This unwarranted economic optimism can lead to a self-
perpetuating pattern of investment behavior.

Investors begin to believe that the recent rise in prices predicts the future and they continue to
invest heavily. Asset bubbles form, which ultimately burst, leading to panic selling. This scenario can be
followed by a severe economic downturn or recession. Examples of this include the stock market crash
of 1929, the stock market crash of 1987, the dotcom crash of 2001, and the financial crisis of 2007-08.

What Is Risk-Seeking?

Risk-seeking is one's acceptance of greater risk, in finance often related to price volatility and

uncertainty in investments or trading, in exchange for the potential for higher returns. Risk seekers are
more interested in capital gains from speculative assets than capital preservation from lower-risk assets.

Risk-seeking can be contrasted with risk-averse.

KEY TAKEAWAYS

 Risk-seeking refers to an individual who is willing to accept greater economic uncertainty in

exchange for the potential of higher returns.
 Risk-seeking confers a high degree of risk tolerance, or the amount of potential losses an
investor is willing to accept.
 In contrast with risk-seeking investors, risk-averse investors seek low-risk investments and are
willing to accept a lower rate of return because of the desire to preserve capital.
 Examples of asset types that might attract a risk-seeking investor include options, futures,
currencies, penny stocks, alternative investments, cryptocurrencies, and emerging market
equities.

Understanding Risk-Seeking

Risk-seeking individuals leverage the trade-off between risk and return by accepting more risk in
hopes of above-average returns. In general, higher-risk investments demand higher expected return
potential, although the quality of the asset in question must be considered beforehand to ascertain
whether there is sufficient return potential to justify the risk involved.

Some examples of types of assets that risk-seeking investors would be attracted to would
be small-cap equities, derivatives, emerging market equities and debt, currencies of developing
countries, junk bonds, and commodities, to name just a few.

Risk-seeking might also describe entrepreneurs who are willing to give up the stability of

salaried employment at an established company to start their own companies in the hope of a greater
financial and emotional payoff.
Special Considerations

Risk-seeking behavior tends to rise in bull markets, when investors, encouraged by gains in the
financial markets, are coaxed into thinking that the good times will continue. There is always a subset of
risk seekers who orient their strategies around high-risk/high-return investments. Others, however, may
shed their discipline to chase momentum stocks, for example, or try their luck with a hot initial public
offering (IPO) that they know little about.

Risk-seeking is an equal opportunity activity sought out by retail investors and professional fund
managers alike, but it can go too far. Examples of when risk-seeking behavior caused many investors and
speculators to lose huge sums of money include the dotcom bubble of the early 2000s and the housing
bubble of the mid-2000s.

Risk-Seeking vs. Risk-Averse

Risk tolerance is an important concept for investors and refers to the degree to which an
investor is willing to accept risk for the potential of a higher return. Risk-averse investors opt for low-risk
investments and are willing to accept a lower rate of return because of the desire to preserve capital.

Financial advisors endowed with common sense counsel their clients to minimize risk-seeking
behavior with respect to their investments. In many cases, particularly for younger individuals, risk-
seeking is part of an overall investment strategy, as risk assets can provide a boost to total portfolio
returns.

For individuals who need more certainty of funds for an imminent house down payment, college
education, or retirement, lower-volatility investments are recommended. Risk-averse investors would
prefer to look to assets such as government securities, blue-chip dividend stocks, investment-
grade corporate bonds, and even certificates of deposit (CDs).

What Is the Prospect Theory?

Prospect theory assumes that losses and gains are valued differently, and thus individuals make
decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion"
theory, the general concept is that if two choices are put before an individual, both equal, with one
presented in terms of potential gains and the other in terms of possible losses, the former option will be
chosen.

How the Prospect Theory Works

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make

a choice between probabilistic alternatives where risk is involved and the probability of different
outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos
Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made
when compared to the expected utility theory.

The underlying explanation for an individual’s behavior, under prospect theory, is that because
the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as
being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is
generally perceived as greater.
 

Although there is no difference in the actual gains or losses of a certain product, the prospect
theory says investors will choose the product that offers the most perceived gains.

Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual
than does an equivalent amount of gain, so given choices presented two ways—with both offering the
same result—an individual will pick the option offering perceived gains.

For example, assume that the end result is receiving $25. One option is being given the straight
$25. The other option is gaining $50 and losing $25. The utility of the $25 is exactly the same in both
options. However, individuals are most likely to choose to receive straight cash because a single gain is
generally observed as more favorable than initially having more cash and then suffering a loss.

Types of Prospect Theory

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain
outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals
avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when
one of their options is a sure loss.

The isolation effect occurs when people have presented two options with the same outcome,
but different routes to the outcome. In this case, people are likely to cancel out similar information to
lighten the cognitive load, and their conclusions will vary depending on how the options are framed.

KEY TAKEAWAYS

 The prospect theory says that investors value gains and losses differently, placing more weight
on perceived gains versus perceived losses.
 An investor presented with a choice, both equal, will choose the one presented in terms of
potential gains.
 The prospect theory is part of behavioral economics, suggesting investors chose perceived gains
because losses cause a greater emotional impact.
 The certainty effect says individuals prefer certain outcomes over probable ones, while the
isolation effect says individuals cancel out similar information when making a decision.

Prospect Theory Example

Consider an investor is given a pitch for the same mutual fund by two separate financial
advisors. One advisor presents the fund to the investor, highlighting that it has an average return of 12%
over the past three years. The other advisor tells the investor that the fund has had above-average
returns in the past 10 years, but in recent years it has been declining. Prospect theory assumes that
though the investor was presented with the exact same mutual fund, he is likely to buy the fund from
the first advisor, who expressed the fund’s rate of return as an overall gain instead of the advisor
presenting the fund as having high returns and losses.