Regret Aversion

Module 2, Topic 4
Dr Sana Moid, ABSL

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 Session Outcome
• This session aims at discussing the concept of Regret Theory and its
influence on various aspects of Investment and Financial Decisions
including the concept of :

• Fear of Regret in Investment Decision

• Reasons behind fear of regret
• Anticipatory Regret
• Minimizing fear of regret

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 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.

• When investing, regret theory can either make investors risk averse, or it

can motivate them to take higher risks.

• When people fear that their decision will turn out to be wrong in
hindsight, they exhibit regret aversion. Regret-averse people may fear the
consequences of both errors of omission (e.g. not buying the right
investment property) and commission (e.g. buying the wrong investment
property)

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• 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 will ask
questions and research any stocks that his friend recommends.

• 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 will be less risk-averse and will likely buy any
stocks that his friend recommends in the future without conducting any
background research of his own.

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• Regret theory rests on two fundamental assumptions: first, that many
people experience the sensations called as regret and rejoicing; and second
that in making decisions under uncertainty they try to anticipate and take
account of those sensations.

• In other words, regret theory assumes that agents are rational but base
their decision not only on expected payoffs but also on expected regret . It
is not suggested that all individuals who act according to their theory must
violate the conventional axioms. They shall challenge the idea that the
conventional axioms constitute the only acceptable basis for rational choice
under uncertainty.

• Both prospect and regret theories were used to explain numerous evidences of
violations of the expected utility theory axioms. Even though these two theories
describe two different well documented behavioral biases they both assume that a
person compares his well being (consumption, wealth, portfolio return, etc. ) with
some benchmark.
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 ASSUMPTIONS

• The main assumption of regret theory is that people after making their
decisions under uncertainty may have regrets if their decision turn out to
be wrong even if they appeared correct with information available ex-
ante. This very intuitive assumption implies that person’s utility function
among other things should depend on the realization of not chosen and in
this sense irrelavent, alternatives.

• Regret theory assume that the expected utility of an option depends on

the calculus of pain and plesuare associated with the outcomes of that
option

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 Regret Theory and Investment Process

• Investors can reduce their fear of regret from making incorrect investment
decisions by automating the investment process. A strategy like formula investing,
which strictly follows prescribed rules for making investments, removes most of
the decision-making process about what to buy when to buy and how much to
buy.

• Investors can automate their trading strategies and use algorithms for execution
and trade management. Using rules-based trading strategies reduces the chance of
an investor, making a discretionary decision based on a previous investment
outcome. Investors can also backtest automated trading strategies, which could
alert them to personal bias errors when they were designing their investment
rules .

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• Regret aversion can also unnecessarily prevent investors from deviating
from a habitual course when favorable opportunities arise. For example, if
an investor always owned short term bonds for fear of stock-market
volatility, and then stock prices plummeted to a point where high-quality
businesses could be bought cheaply, regret aversion could prevent them
from breaking their bond-buying habit to capitalize on the high-potential
stocks.

• Briefly, regret aversion bias can cause various investment mistakes: (i) Regret
aversion can cause investors to be too conservative in their investment choices; (ii)
Regret aversion can cause investors to shy away, unduly, from markets that have
recently gone down; (iii) Regret aversion can cause investors to hold onto losing
positions too long; (iv) Regret aversion leads investors to prefer stocks of
subjectively designated good companies, even when an alternative stock has an
equal or a higher expected return; (v) Regret aversion can cause “herding behvior”
because, for some investors, buying into an apparent mass consensus can limit the
potential for future regret

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 Avoiding Regret Aversion

• To avoid such a behavioral trap and counterbalance the weight of regret

aversion, investors must recognize that failure to make a decision or take
action is a choice in itself. In effect, it is a passive decision to maintain the
status quo and keep their current portfolio holdings.

• Investors should regularly asses estimated values and allocate capital

accordingly, maximizing the best alternatives within a given timeframe,
risk budget or tax situation. Perhaps they can use regret aversion to their
benefit, recognizing that failure to take these steps will likely produce poor
outcomes over the long run.

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 Regret Aversion & Loss Aversion

• Differently, Loss Aversion stems from the fact that losing is more
psychologically effective than winning. For instance, Alliance Bernstein
performed a study which displayed 92% popularity for an investment with
an 80% risk.

• In addition, Loss Aversion is the analogy between receiving a penalty and

a reward. This theory explains how individuals are often more influenced
by the fear of discipline than the excitement of reward. Therefore,
suggesting why investors will go for high-end risks.

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• There are three personality traits of the "Regret/Loss Averse Investor.“

• Fear: worrying about the consequences of purchasing the wrong property

• Stubbornness: having the reluctance to hold onto the property even in

bear markets

• Cultural Background: An investor from a lower economic position might be

more inclined to take a higher risk in order to obtain greater rewards.

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 Summary
• Regret Theory or Fear of Regret plays a very important role in financial
decision taken by human beings.

• It is only because of the fear of regret that people use to take decisions
which may be irrational.

• The suitable way to minimize the fear of regret is to generate as many

options as possible, or at least a suitable number so there should not be
regret of choosing between two alternatives

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Suggested Reading

https://repository.law.umich.edu/cgi/viewcontent.cgi?
article=1406&context=mjlr

https://pure.uvt.nl/ws/portalfiles/portal/641736/zeelenberg-
1996_OBHDP.pdf

http://static.luiss.it/hey/ambiguity/papers/Hayashi_2008.pdf

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