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It is said that fear and greed drive markets. I would like to add regret to this list. Why regret? Because it’s often how fear and greed enter into our investment decision-making.
Consider two common investor acronyms: FOMO, fear of missing out and TINA – there is no alternative. Could there be any better example of regret inciting investors to greed than the fear of missing out? The phrase “there is no alternative” implies that a choice is made reluctantly. In other words, the alternatives would all lead to regret.
I have been struggling to deal with regret aversion and its effect on my decision-making for a while now. Like many investors, I’m a perfectionist by nature. This makes me especially vulnerable to regret aversion.
I try to review all of my investment decisions as part of my deliberate practice to become a better investor. This is how I discovered that regret aversion is a common theme underlying several of my mistakes. Honest self-examination is an important part of deliberate practice.
What is deliberate practice? The Harvard Business Review article The Making of an Expert by Ericsson, Prietula and Cokely describes it this way…
Not all practice makes perfect. You need a particular kind of practice—deliberate practice—to develop expertise. When most people practice, they focus on the things they already know how to do. Deliberate practice is different. It entails considerable, specific, and sustained efforts to do something you can’t do well—or even at all. Research across domains shows that it is only by working at what you can’t do that you turn into the expert you want to become.
We’ll discuss why regret aversion has led me to make some poor decisions shortly. First, it’s helpful to elaborate on the nature of regret and why it’s a part of every investment decision that we make.
Deliberate practice wouldn’t be complete without also trying to figure out a way to manage the negative effects of regret. I will write about this in a future post.
My reading on regret and its effects on decision-making revealed several important points:
Regret has a profound emotional impact. A study by Shimanoff (1984) found that regret was the second-most common emotion mentioned in conversation. Only love was more popular.
Regret is a comparative emotion. We feel regret when we compare what’s happened with what could have happened. We create the potential for regret every time we ask a “what if…“ question. I’ve learned that the key to managing regret is avoiding the “wrong” comparisons. We need to carefully select comparisons that will teach us the right lessons. This is the first clue to managing the impact of regret on investing.
Other comparative emotions include anger, frustration, disappointment, distrust, guilt, sadness and shame.
Regret requires a decision. It’s impossible to feel regret without making a decision. For example, you could feel disappointment if you go outside and it rains. But you would only feel regret if you decided not to bring your umbrella with you.
Regret feels worse for choices that were taken. Kahneman and Tversky (1982) found that feelings of regret are stronger when we’ve decided to act. In other words, we regret perceived errors of commission more than errors of omission.
Suppose you scan the 52-week-high list and notice that Nvidia (NVDA) is up 204.52% over the last 12 months (while the S&P 500 is up only 18.52%). You might think “I wish I’d heard about Nvidia twelve moths ago” and quickly move on without feeling much regret.
But what if you’d read a magazine article about Nvidia 12 months ago? What if that article explained that graphical processing units (GPU) were increasingly used for machine learning and that Nvidia was a leading manufacturer of GPUs? What if you also looked up the company’s fundamentals on Value Line? What if you’d also seen that the stock featured in the 13F reports of several prominent hedge funds? Finally, what if you decided after only a cursory investigation that it looked expensive?
In the latter case, you would have experienced stronger feelings of regret because you chose not to act. I wish I could say that this his happened to a “friend” of mine but I can’t. Unfortunately it happened to me.
Regret can be a positive motivator. Not all regret is bad. If viewed appropriately, it can be a powerful motivator to learn, grow and consequently improve our performance. This is the second clue to learning how to manage regret.
The most disappointing thing about missing Nvidia wasn’t that I had missed out on a +200% gain. Every investor, even the very best, frequently miss opportunities. My regret is that I didn’t really have a disciplined process to ensure that I followed up on my ideas.
I’m now focused on building a systematic process to keep track of investment ideas. In other words, my regret has motivated me to improve my investment process through deliberate practice.
Regret is stronger for comparisons that are easily made. Our feelings of regret are more intense when we can easily and clearly measure the consequences of our choices.
Imagine that, after graduation, you decided to break up with your high-school sweetheart. As the years go by, you fall out of touch. Perhaps you moved to a different city and met someone new. You might occasionally think back to your youth and wonder what might have been if you’d stayed together. But you probably won’t feel regret.
Suppose instead that you decide to follow your high school sweetheart on Facebook (assume that it existed at the time). You find out on Facebook that they’re now successful and wealthy. Their profile is full of photos from exotic holiday destinations around the world. What’s more, they’re in a relationship with a personal trainer and they look fantastic. This might prompt feelings of regret.
Regret varies across individuals and circumstances. Let’s take our high school sweetheart analogy a step further. You may not find the Facebook comparison troubling if you’re happy and successful. But what if you’re life hasn’t turned out the way that you expected? In this case, your feelings of regret are likely to be stronger.
I’ve learned that we experience regret differently when we make decisions:
- On behalf of other people
- As part of a group
- Without having any skin in the game
- Knowing that our results will be judged by others and with the benefit of hindsight.
Regret influences our choices as we are making them. Regret isn’t just experienced after the fact. We actively anticipate regret and take it into account when making decisions. This is known as regret aversion.
Regret aversion is different from risk aversion or loss aversion. We sometimes take more risk to avoid feeling regret. For example, the gambler who accepts a “double or nothing” bet is taking an even bigger risk to avoid the regret that comes with facing up to a loss.
What does Regret Aversion Look Like?
Here are some of my worst mistakes. Each mistake was largely due to regret aversion:
- “Company XYZ looks fairly-priced, but there’s a chance that it might fall in value. I don’t want to feel like an idiot if it drops 10% after I buy it. So, I’ll wait and buy it on the next pull-back.” The stock doubles.
- “Stock ABC is up 10% since I bought it and the outlook for the company is improving. It’s still below my estimate of value. I should buy more. But what if I’m wrong? I’ll wait and see what happens.” ABC is up another 30% in less than 3 months.
- “DEF is well positioned to take advantage of rising interest rates. I’ve done my homework on it, including reading the 10k from cover to cover. But Tom thinks I’d be nuts to buy US financials. He says you can’t trust the book value. Tom thinks the S&P 500 is way over-priced and that we’re due for a crash. What if he’s right? Maybe I should wait?” DEF is up almost 100% in 9 months.
- “I really should sell RST, its down 10% since I bought it, but more importantly revenues are still falling and the fundamentals aren’t improving. But what if the new product they’re working on is a success? What if they use the billions that they have in cash to make an acquisition? The stock will rally and I’ll feel stupid for missing it. Maybe I should wait.” RST falls a further 15%.
Why does Regret Aversion Matter?
Simply because every investment decision that we face carries the risk that regret aversion will lead us astray.
Investing involves making decisions about the future and with incomplete information. It requires making decisions in the face of uncertainty. In many cases, there is no way of finding out if the decision was correct until several years into the future. If that doesn’t sound like a breeding ground for regret aversion then I don’t know what does.
Every decision requires us to ask “what if?” In other words, it forces us to make comparisons.
We all get to see our mistakes in high-definition; thanks to real-time market pricing, performance surveys and monthly returns.
Regret aversion is one of the main causes of the disposition effect – the tendency to sell winners while holding onto losers.
We can’t avoid regret aversion entirely, but we can learn to manage it if we:
- Make the right comparisons to help us draw the right conclusions
- Allow it to motivate us to engage in deliberate practice (instead feeding regret aversion)
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Market Fox posts on behavioural finance and decision-making for investors:
- Managing the Disposition Effect
- Prospect Theory – Explained in Under 2 Minutes
- The Disposition Effect – Why it Matters
- Prospect Theory – A Beginner’s Guide