21
Emotional Bias #6: Regret Aversion Bias
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 retirement plan contributions 50/50 between bonds and equities.
—Harry Markowitz, father of Modern Portfolio Theory
Bias Description
Bias Name: Regret aversion bias
Bias Type: Emotional
General Description
People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to avoid the emotional pain of regret associated with poor decision making. Regret aversion makes investors, for example, unduly apprehensive about breaking into financial markets that have recently generated losses. When they experience negative investment outcomes, they feel instinctually driven to conserve, to retreat, and to lick their wounds—not to press on and snap up potentially undervalued stocks. However, periods of depressed prices often present the greatest buying opportunities. People suffering from regret aversion bias hesitate most at moments that actually merit aggressive behavior.
Regret aversion does not come into play only when following a loss; it can also affect a person's response to investment gains. People exhibiting regret aversion can be reluctant, for example, to sell a stock whose value has climbed recently—even if objective indicators attest that it's time to pull out. Instead, regret-averse investors may cling to positions that they ought to sell, pained by the prospect that a stock, once unloaded, might soar even higher.
Example of Regret Bias
The following case study illustrates both aspects of regret bias: error of commission and error of omission. The case shows a regret-averse investor under two sets of circumstances: (1) an investor experienced a loss and regrets his decision to invest; and (2) an investor missed an opportunity to invest in something that later appreciated in value and regrets his failure to reap profits.
Suppose that Jim has a chance to invest in Schmoogle, Inc., an initial public offering (IPO) that has generated a great buzz following its recent market debut. Jim thinks that Schmoogle has high potential and contemplates buying in because Schmoogle's price has recently declined by 10 percent due to some recent market weakness. If Jim invests in Schmoogle, one of two things will happen: (1) Schmoogle will drop further (Jim made the wrong decision), or (2) Schmoogle will rebound (Jim made the right decision). If Jim doesn't invest, one of two things will happen: (1) Schmoogle will rebound (Jim made the right decision), or (2) Schmoogle will drop further (Jim made the wrong decision).
Suppose that Jim does invest and Schmoogle goes down. Jim will have committed an error of commission because he actually committed the act of investing and will likely feel regret strongly because he actually lost money.
Now suppose that Jim does not invest and Schmoogle goes up. Jim will have committed an error of omission because he omitted the purchase of Schmoogle and lost out. This regret may not be as strong as the regret associated with the error of commission. Why? First, as we learned in Chapters 16 through 18, investors dislike losing money more than they like gaining money. Second, in the first possibility, the investor actually committed the act of investing and lost money; in the second possibility, the investor merely did not act and only lost out on the opportunity to gain.
Implications for Investors
Regret aversion causes investors to anticipate and fear the pain of regret that comes with incurring a loss or forfeiting a profit. The potential for financial injury isn't the only disincentive that these investors face; they also dread feeling responsible for their own misfortunes (because regret implies culpability, whereas simple disappointment does not). The anxiety surrounding the prospect of an error of commission, or a “wrong move,” can make investors timid and can cause them to subjectively and perhaps irrationally favor investments that seem trustworthy (e.g., “good companies”). Suppose that regret-averse Jim is now considering two investments, both with equal projected risk and return. One stock belongs to Large Company, Inc., while the other confers a share in Medium-Size Company, Inc. Even though, mathematically, the expected payoffs of investing in these two companies are identical, Jim will probably feel more comfortable with Large Company. If an investment in Large Company, Inc., fails to pay off, Jim can rationalize that his decision making could not have been too egregiously flawed, because Large Company, Inc. must have had lots of savvy investors. Jim doesn't feel uniquely foolish, and so the culpability component of Jim's regret is reduced. Jim can't rely on the same excuse, however, if an investment in Medium-Size Company fails. Instead of exonerating himself (“Lots of high-profile people made the same mistake that I did—perhaps some market anomaly is at fault?”), Jim may condemn himself (“Why did I do that? I shouldn't have invested in Medium-Size. Only small-time players invested in Medium-Size, Inc. I feel stupid!”), adding to his feelings of regret. It's important to recall here that Large Company and Medium-Size Company stocks were, objectively, equally risky. This underscores the fact that aversion to regret is different from aversion to risk. Box 21.1 reviews five investor mistakes that can stem from regret aversion bias. Remedies for these biases will be reviewed in the Advice section.
Am I Subject to Regret Bias?
These questions are designed to detect signs of emotional bias stemming from regret aversion. To complete the test, select the answer choice that best characterizes your response to each item.
Regret Aversion Bias Test
Question 1: Suppose that you make an investment in mutual fund ABC and that over the next 12 months ABC appreciates by 10 percent. You contemplate selling ABC for normal portfolio rebalancing purposes, but then come across an item in the Wall Street Journal that sparks new optimism: Could ABC climb even higher? Which answer describes your likeliest response, given ABC's recent performance and this new information?
- I think I'll hold off and sell later. I'd really kick myself if I sold now and ABC continued to go up.
- I'll probably sell. But I'll still kick myself if ABC appreciates later on.
- I'll probably sell the stock without any second thoughts because rebalancing is important—regardless of what happens to ABC's price after the transaction.
Question 2: Suppose that you've decided to acquire 200 shares of LMN mutual fund. You purchase 100 shares now at $30 apiece and strategize to wait a few days before picking up the additional 100. Further suppose that soon after your initial buy, the market takes a comprehensive dip. LMN is now trading at $28, with no change in fundamentals. Which answer most closely matches your thought process in this situation?
- I will probably wait until the stock begins to go back up before buying the remaining 100 shares. I really don't want to see LMN fall below $28 because I'd regret my initial decision to buy in.
- I will probably buy the remaining 100 shares. If LMN ends up going below $28, though, I will probably regret my decision.
- I will probably buy the remaining 100 shares. Even if LMN falls below $28, I don't think I'll experience a lot of regret.
Question 3: Suppose you have decided to invest $5,000 in the stock market. You have narrowed your choices down to two mutual funds: one run by Big Company, Inc, and one run by Small Company, Inc. According to your calculations, both funds have equal risk and return characteristics. Big Company is a well-followed, eminently established company, whose investors include many large pension funds. Small company has performed well but has not garnered the same kind of public profile as Big Company. It has few well-known investors. Which answer most closely matches your thought process in this situation?
- I will most likely invest in Big Company because I feel safe taking the same course as so many respected institutional investors. If Big City does decline in value, I know I won't be the only one caught by surprise—and with so many savvy professionals sharing my predicament, I could hardly blame myself for excessively poor judgment.
- I will most likely invest in Big Company because if I invested in Small Company and my investment failed, I would feel like a fool. Few well-known investors backed Small Company, and I would really regret going against their informed consensus only to discover that I was dead wrong.
- I would basically feel indifferent between the two investments, since both generated the same expected parameters for risk and return.
Test Result Analysis
Questions 1, 2, and 3: People answering “a” or “b” to any question may harbor susceptibility to regret aversion bias.
Advice
This section is organized to address each of the pitfalls of regret aversion bias that are enumerated in Box 21.1.
Investing too conservatively. No matter how many times an investor has been “burned” by an ultimately unprofitable investment, risk (in the context of proper diversification) is still a healthy ingredient in any portfolio. Efficient frontier research can be very helpful here. Investing too conservatively doesn't place an investor's assets in any acute danger—by definition, an excess of conservatism denotes a relative absence of risk. However, refusing to assume a risk often means forgoing a potential reward. Investors who swear off risky assets due to regret aversion may see less growth in their portfolios than they could otherwise achieve, and they might not reach their investment goals.
Staying out of the market after a loss. There is no principle more fundamental in securities trading than “buy low, sell high.” Nonetheless, many investors' behavior completely ignores this directive. Again, human nature is to chase returns, following “hot” money. Of course, it is possible to profit from following market trends … the problem is, you never know when the balloon is going to pop and cause, for example, yesterday's coveted security to plummet 40 percent in an afternoon. Disciplined portfolio management is crucial to long-term success. This means buying at times when the market is low and selling at the times when the market is up.
Holding losing positions too long. An adage on Wall Street is “The first loss is the best loss.” While realizing losses is never enjoyable, the wisdom here is that following an unprofitable decision, it is best to cut those losses and move on. Everyone missteps occasionally—even the world's savviest traders. Investors shouldn't regret realizing their losses. If people can learn to feel less grief when realizing that they have incurred losses, then the pain of owning up to a loss can be reduced and the effects of regret aversion in such instances can be lessened.
Herding behavior. Often, investors subject to pack mentalities have a hard time explaining the rationale for a new investment if it does not fit into their long-term plan. Disconcerted by their own hesitation, many investors at this point will step back and reconsider the consensus of the herd. Others, though, may rationalize: “This is my time to take a risk.” This is not, in and of itself, a dangerous statement. Investors are permitted, on occasion, to gamble. They must, however, understand the stakes and the magnitudes of the gambles they undertake.
Preference for good companies. Investors often prefer buying stock in “good” companies like Coca-Cola. Such household names have seen their ups and downs, however, just like competitor firms. Investors sometimes limit themselves to good companies simply because they fear the regret they might experience if an investment in a lesser-known company doesn't work out. Remember that high-profile brands don't necessarily deliver returns either. Coke is certainly recognizable, but that doesn't mean that either company's stock constitutes a sure thing.
Remember that you may also experience regret when a stock begins to decline after you've held it for too long. Moreover, a helpful approach is to attempt to set aside any emotions that might be impacting the sell decision. Once you feel certain, make a choice—and stick to it. You can always buy in again later on if the stock does indeed represent a good investment opportunity.