Regret aversion

What Is Regret Aversion?

Regret aversion is a cognitive bias in behavioral finance where individuals make decisions designed to minimize the pain of potential future regret, often leading to suboptimal financial outcomes. This bias influences investment choices as people attempt to avoid feeling remorse over a missed opportunity or a poor decision. It falls under the broader category of behavioral finance, which studies the psychological influences on economic decision-making. Investors exhibiting regret aversion might choose safer, lower-return assets to avoid the regret of losses, or they might hold onto losing investments too long, hoping to avoid the regret of realizing a loss.

History and Origin

The concept of regret aversion gained prominence within the field of behavioral economics through the work of Graham Loomes and Robert Sugden, who introduced "regret theory" in a 1982 paper published in The Economic Journal.¹⁸, ¹⁹, ²⁰, ²¹, ²² This theory proposed an alternative to the traditional expected utility theory, suggesting that individuals incorporate anticipated regret and rejoicing into their decision-making process. Rather than solely maximizing utility, people consider how they will feel about the outcome compared to alternative choices they could have made.

Key Takeaways

• Regret aversion is a cognitive bias influencing financial decisions, driven by the desire to avoid future remorse.
• It can lead investors to make choices that are not always rational or optimal for their financial goals.
• This bias is a core concept in behavioral finance, explaining deviations from traditional economic models.
• Examples include holding onto losing stocks or avoiding potentially high-return, but risky, investments.

Interpreting Regret Aversion

Regret aversion manifests in various ways within financial behavior. For instance, an investor might choose not to sell a losing stock because doing so would crystallize the loss and the accompanying feeling of regret. This is closely related to the disposition effect, where investors sell winning investments too early to "lock in" gains and avoid the regret of seeing those gains evaporate, while holding onto losing investments too long.¹⁷ Conversely, it can also lead to herd behavior, where individuals follow the actions of the majority to avoid the regret of being wrong alone.¹⁶ Understanding regret aversion helps financial professionals interpret why clients might deviate from financially sound advice and develop strategies to mitigate its negative impact.

Hypothetical Example

Consider an investor, Sarah, who has $10,000 to invest. She has two options:

1. Invest in a well-established blue-chip stock with a modest but stable historical return of 5% per year.
2. Invest in a promising but volatile growth stock with the potential for 20% returns, but also a 30% chance of a 10% loss.

If Sarah suffers from high regret aversion, she might choose the blue-chip stock, even if her risk tolerance suggests she could handle the growth stock's volatility. Her reasoning might be: "If I choose the growth stock and it loses money, I'll regret not having picked the safe blue-chip stock." The potential regret of losing money outweighs the potential joy of higher returns. Even if the growth stock performs exceptionally well, she avoids the choice that could have led to greater potential regret. This decision-making process highlights how fear of future remorse can override purely rational financial calculation, impacting long-term wealth accumulation.

Practical Applications

Regret aversion plays a significant role in various aspects of investing and personal finance. It can influence portfolio construction, leading individuals to underweight riskier assets or overemphasize perceived "safe" investments, even if this means sacrificing potential returns. This bias is also evident in phenomena such as inaction, where investors delay making decisions (e.g., rebalancing a portfolio or selling underperforming assets) to avoid potential regret associated with making a change that might turn out to be wrong.

Furthermore, regret aversion can impact retirement planning. Individuals might be hesitant to allocate sufficient funds to equities, even for long-term horizons, due to the fear of market downturns and the resulting regret of seeing their savings diminish. Financial advisors often encounter regret aversion when discussing diversification strategies, as clients may be reluctant to invest in unfamiliar asset classes for fear of regretting the decision if those investments underperform.¹⁴, ¹⁵ This can lead to under-diversification or a preference for familiar, albeit less optimal, investments. For example, some investors exhibit a familiarity bias, preferring investments in their own country or company, which can increase portfolio risk.¹², ¹³

The Federal Reserve regularly conducts surveys, such as the Survey of Household Economics and Decisionmaking (SHED), that examine factors influencing household financial well-being, including savings and investment behaviors that can be affected by behavioral biases.¹¹ Insights from such surveys can help policymakers and financial educators understand how psychological factors like regret aversion impact real-world economic choices. The Federal Reserve Bank of San Francisco, among other institutions, publishes research on household finance and behavioral economics, highlighting the broad impact of these psychological biases on economic stability.⁸, ⁹, ¹⁰

Limitations and Criticisms

While regret aversion offers a compelling explanation for many observed financial behaviors that deviate from rational choice theory, it does have limitations. Critics sometimes point to the difficulty in precisely measuring or quantifying anticipated regret, as it is an internal psychological state. Furthermore, while regret aversion can explain certain suboptimal decisions, it doesn't always account for all aspects of irrational behavior. Other cognitive biases, such as overconfidence or anchoring, can also play significant roles, sometimes interacting with regret aversion in complex ways.⁵, ⁶, ⁷

Another critique is that focusing solely on regret aversion might overlook the potential benefits of learning from past mistakes. While the immediate impulse might be to avoid regret, a more constructive approach involves analyzing prior decisions to improve future outcomes. However, the emotional impact of regret can sometimes be so strong that it hinders rational learning and adaptation. An instance where negative sentiment, possibly linked to regret, can lead to widespread financial distress is seen in the broader context of consumer debt, where individuals may fall into traps of borrowing more than they can repay, leading to significant financial hardship and compounding feelings of remorse.², ³, ⁴

Regret Aversion vs. Loss Aversion

Regret aversion and loss aversion are distinct but related concepts in behavioral finance. Loss aversion describes the tendency for individuals to feel the pain of losses more acutely than the pleasure of equivalent gains. For example, losing $100 might feel twice as bad as gaining $100 feels good. This can lead investors to avoid any situation where a loss is possible.

Regret aversion, on the other hand, is specifically about avoiding the feeling of remorse that comes from making a decision that turns out to be wrong, or from failing to make a decision that would have led to a better outcome. While loss aversion focuses on the magnitude of the outcome (the loss itself), regret aversion centers on the emotional consequence of the decision-making process. An investor might sell a winning stock early due to loss aversion (fear of the gain turning into a loss), but they might hold onto a losing stock due to regret aversion (fear of regretting the sale if the stock recovers). Both biases can lead to irrational financial choices, but they stem from different psychological motivations.¹

FAQs

What is an example of regret aversion in investing?

An example is holding onto a losing stock because selling it would force the investor to confront the "mistake" of buying it, leading to the pain of regret. Conversely, it can also manifest as avoiding a potentially high-return investment for fear of regretting the decision if it performs poorly.

How does regret aversion affect financial decisions?

Regret aversion can lead individuals to make risk-averse choices, delay important financial actions like rebalancing a investment portfolio, or engage in herd behavior to avoid being solely responsible for a bad outcome. These behaviors often result in suboptimal long-term financial performance.

Is regret aversion a cognitive bias?

Yes, regret aversion is considered a cognitive bias. It's a systematic pattern of deviation from rationality in judgment, where individuals allow their fear of future regret to influence their decisions, rather than purely rational calculation.

Can regret aversion be overcome?

Mitigating regret aversion often involves developing a structured investment strategy, focusing on long-term goals rather than short-term fluctuations, and seeking objective financial advice. Understanding that perfect outcomes are impossible and accepting uncertainty can also help reduce the emotional impact of potential regret. Practicing dollar-cost averaging can also help to alleviate regret, as it automates investment decisions and reduces the impact of market timing.