Summit Financial Resources, Inc.
Cohen’s Corner
A Discussion on Behavioral Finance
By Daniel Cohen
Volume 10
Regret Aversion Bias
Regret is a human
emotion characterized
by feelings of sadness or
sorrow resulting from
something one has done
or something one has
failed to do. Regret
tends to be particularly
powerful and intense, and individuals often go to
great lengths to avoid this wounding emotion.
COHEN’S
CORNER
In the investment arena, the behavior of individuals
can be dictated by the desire to avoid regret. When
this is the case, the investor is said to be subject to
an emotional bias known in behavioral finance as
regret aversion. If an individual’s judgement is
tainted by regret aversion, decisions are likely to be
irrational, leading to poor investment results.
Regret Aversion Bias Explained
Regret aversion occurs when one’s behavior is
governed by a desire to avoid the pain associated
with making poor investment decisions. The bias
comes in two varieties – one relating to errors of
commission and one relating to errors of omission.
In regret aversion related to errors of commission,
investors show a propensity to avoid making a
decision because they fear it will be turn out poorly,
which would engender feelings of regret. The classic
example of this is an investor who holds on to a
security that has depreciated, not because they
believe it offers good value, but because they want
to avoid the feeling of shame that would arise if they
sold the security and it appreciated thereafter.
In regret aversion related to errors of omission,
investor action is driven by the desire to dodge
feelings of remorse that occur after missing out on
profitable investment opportunities that others are
enjoying. Therefore, they invest with the crowd. This
not only alleviates the investor’s fear of missing out,
it also tends to moderate the intensity of regret that
occurs if the investments turn sour, as the burden of
responsibility is shared with the group rather than
experienced alone. The typical example of regret
aversion relating to errors of omission involves an
investor who purchases a “hot” security (i.e., one
that has been appreciating in value while being
touted by investors and financial media). The
decision to purchase the security is not based on
attractive valuation, diversification benefits, or any
other rational grounds for investment. Rather, it is
made because the investor fears experiencing the
regret that would result if the security continued its
march higher and they did not reap the benefits.
When this type of behavior occurs en masse, it is
known as the herding effect. The herding effect was
a major contributor to the inflating of the technology
bubble in the early 2000s. In the ensuing crash,
investors held on to losers for too long due to regret
aversion associated with errors of commission.
Regret Aversion Consequences
Regret aversion can cause investors to hold positions
for longer than is justified by a rational, analytical
assessment of risk and return characteristics. By
taking no action, the investor avoids having to bear
the burden of responsibility for potentially selling a
security too early. This behavior can result in
investors maintaining positions with poor prospects,
resulting in suboptimal investment outcomes.
Regret aversion may also result in individuals shying
away from purchasing securities that have recently
experienced significant losses. Investors avoid
securities that have recently depreciated sharply
because emotion and faulty intuition lead them to
believe past losses are a harbinger of future declines.
In seeking to avoid the regret that would arise from
unsuccessfully trying to “catch a falling knife,” they
stay away from securities experiencing periods of
depressed prices. As such, they often miss out on
excellent investment opportunities.
Investors subject to regret aversion may also be
reluctant to buy into securities that have
appreciated rapidly for fear they may be entering
the position at its zenith, known colloquially as
“buying the top”. Though a security may be trading
at or near an all-time high, it may nonetheless be
attractively priced, with favorable risk/reward
dynamics. However, investors with regret aversion
are unwilling to buy because they are fearful of the
regret that would arise if they did in fact “buy the
top.” This behavior protects the investor emotionally
but it is deleterious to performance, as favorable
opportunities are shunned for irrational reasons.
20161013-0913
Summit Financial Resources, Inc.
As touched on earlier, regret aversion can lead to
herding behavior. Investors fear regret engendered
by continuing to miss out on gains experienced by
other investors who own popular securities that
have been appreciating in value. They buy in to
these securities with little regard for valuation or
future prospects. One only needs to harken back to
the bursting of the technology bubble, where
investors with little to no experience stampeded into
technology stocks for no other reason than fear of
missing out on gains experienced by others, to see
the potential injurious nature of this behavior.
Importantly, regret aversion can cause investors to
be overly conservative in their portfolio positioning.
Individuals may have experienced great remorse
from prior losses incurred from investments in
stocks and other risky assets. In order to avoid
experiencing these feelings again, they may gravitate
towards more conservative assets, such as Treasury
bonds or cash. High concentrations of defensive
assets may be inappropriate for certain investors. In
many cases, such positioning reduces the likelihood
of an investor achieving their financial goals.
Detection of Regret Aversion
Your financial advisor can help identify regret
aversion. Below is one example of a question he or
she may ask in order to detect the bias1:
Question 1:
Suppose you make an investment in Stock ABC, and over the
next six months, ABC appreciates by your target of 15
percent. You contemplate selling but then come across an
item in the Financial Times that rehashes the company’s
recent successes and also sparks new optimism. You wonder
whether ABC could climb even higher. Which answer
describes your likeliest response given ABC’s recent
performance and the FT article?
A. I think I’ll hold off and wait to see what happens. I’d
really “kick” myself if I sold now and ABC continued to
go up.
B. I’ll probably sell because ABC has hit the target I set,
and I try to stick to the targets I set.
If an individual selects choice A, they may be prone
to this issue’s bias.
In addition to formal questionnaires, an advisor may
discover regret aversion during the normal course of
the client/advisor relationship. It is the job of the
advisor to be in tune with the rationale behind the
1
Michael Pompian, “The Behavioral Biases of Individuals,” in
2016 CFA Level III Volume 2: Behavioral Finance, Individual
Investors, and Institutional Investors. CFA Institute, 07/2015.
VitalSource Bookshelf Online.
investment decisions made by the client. If a client is
holding securities too long, jumping into hot stocks,
exhibiting unwarranted hesitancy to invest in a
security based on recent price action, or is overly
conservative because of prior losses experienced in
growth assets, the advisor can identify and help
remedy these mistakes.
Dealing with Regret Aversion
Regret aversion is one of the more innocuous
emotional biases - that is to say the intensity of
emotion provoked when an advisor confronts a
client about regret aversion is low relative to most
other emotional biases. As such, your advisor should
not hesitate to attempt to remedy regret aversion if
he believes it is affecting your investment decisions.
To this end, education is paramount. Your advisor
should explain to you the negative ramifications that
inefficiencies stemming from regret aversion can
cause on your portfolio. He or she should dissuade
you from investing with the crowd, chasing hot
stocks, and holding/selling securities for the wrong
reasons. Through coaching, your advisor can help
you sidestep the tendency to sell winners too soon
and hold losers for too long. Moreover, your advisor
can help design an asset allocation that is
appropriate for your financial circumstances. They
can explain why a particular level of risk is optimal
(neither too risky nor too conservative) for meeting
your financial goals. By consistently reiterating the
importance of a long-term focus and sound,
objective analysis as the basis for investment
decision-making, your advisor can help prevent
injurious tendencies that result from action spurred
by the presence of regret aversion.
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Coming up in Cohen’s Corner:
Next Month’s Bias: Framing
This is the tenth installment in a multi-part series. To access this
piece
as
well
as
other
volumes,
go
to
www.SummitFinancial.com/CohensCorner
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