Does the fear of regret ever impact your decision making? Regret aversion is an emotional bias that causes people to make suboptimal choices or fail to act out of fear that they will make the wrong choice and regret it. Listen to Senior Analyst Toby Koerten as he explains regret aversion, provides interesting examples, and reviews our thoughts on the best way to address emotional biases.

NOTE: This podcast was recorded prior to the rebrand of Finworx as Lirio Finance.

stitcher-podcast-small1
 

Transcript

(* Indicates language updated to reflect current brand and position.)

I’m Toby Koerten*, and today we are going to talk about a behavioral bias known as regret aversion. In its simplest form, regret aversion is a behavioral bias that causes people to choose poorly or fail to act out of fear that they will choose incorrectly and regret their decision. This probably resonates with a lot of our listeners on at least some level. Almost everyone has some hesitation before making major decisions due to fears that it could be a wrong decision and we may regret it in the future. However, for some people, this bias can be extremely prevalent, and can result in poor decision making due to the fear of being wrong and regretting it.

You don’t have to look far to see some everyday examples of regret aversion:

The first example that comes to mind is the example of extended warranties. It is widely documented that purchasing an extended warranty for electronics, furniture, cars, etc. is not a good economic decision. In a world without biases, no one would purchase extended warranties because “Econs,” as Richard Thaler calls the perfect decision-makers in traditional economics, know not to purchase something with a negative expected return. However, most of us have probably been suckered into purchasing an extended warranty on a major purchase at least once in our lives.

Why did we do this?

Sales people are aware of regret aversion, and they will always mention the availability of an extended warranty. Just mentioning the warranty is enough to cause regret aversion to kick in. Once you know that there is a warranty available, your mind may start to think of all the potential things that could go wrong with your purchase. Now that you have an option to buy the warranty, if you decide not to purchase the warranty and any of the bad things happen, you will certainly regret the decision to not purchase the warranty.

As a result, many people would rather spend the money up front, and avoid the pain of regret in the low probability that the extended warranty is needed. This concept was discussed by Braun and Muermann in 2004. Their work shows that regret aversion leads to consumers purchasing insurance for low-value losses because when insurance is available, but is not purchased, and a loss occurs, a regret-averse person will feel this loss very heavily, since they could have chosen to buy insurance but did not

In Thaler’s 1979 paper titled “Toward a Positive Theory of Consumer Choice,” he gives the following example, which he credits to Kahneman and Tversky. Thaler highlights the fact that “members of the Israeli Army display a resistance to trading patrol assignments, even when it would be convenient for both individuals to do so.” He goes on to discuss that “if two men trade assignments and one is killed, the other must live with the knowledge that it could (should?) have been he. By avoiding such trades these costs are reduced.” This is an example of how regret aversion can cause someone to fail to make a rational decision due to the fear of making the wrong choice and then regretting it.

Thaler also discusses some clear impacts that regret aversion has on health care markets. Keep in mind that this paper was written in 1979, so the examples may be a little but outdated, but the principles still apply. He discusses that economists are puzzled by the fact that consumers prefer no deductible or low deductible insurance plans even when, economically, these plans don’t make as much sense. He partially attributes the desire for these low deductible plans to regret aversion. Here is a brief passage from the paper:

“Why do consumers want the first dollar coverage? I believe the reasons involve regret. Most consumers find decisions involving tradeoffs between health care and money very distasteful. This is especially true when the decision is made for someone else like a child. A high deductible policy would force individuals to make many such decisions, at considerable psychic costs. The costs can occur no matter which way the decision is made. Consider a couple which must decide whether to spend $X for a diagnostic test for their child. There is some small probability that the child has a serious disease which could be treated if detected early enough. There will surely be regret if the decision is made not to get the test and the child later is found to have the disease. If the disease can be fatal, then the regret may loom so large that the test will be administered even for very large values of X or very small values of p. Yet once the test is ordered and the likely negative result is obtained, the couple may regret the expenditure, especially if it is large relative to their income. Obviously, these costs are avoided if all health care is prepaid, via either first dollar coverage or a prepaid health organization.”

In these examples, there are two different types of regret aversion. The first is error of commission, which means that an individual makes a wrong choice due to their desire to minimize future regret. For example, purchasing insurance even though it isn’t a rational decision. The second type is an error of omission, which occurs when an individual fails to make a decision out of the fear that they will regret the decision they make. This type explains that reluctance for the Israeli military members to trade shifts.

It is clear how these examples are a departure from rational behavior. Traditional economic models don’t take into account the fact that a person will fail to make a decision due to fear of regret. Traditional economics assumes that an individual will maximize their utility without account for regret aversion and other biases. Now, let’s take a look at some of the academic research surrounding regret aversion.

In a 2011 study, van de Ven and Zeeleberg tested the regret aversion bias in the following way. They ran two separate experiments with lottery tickets that had an equal chance to win a voucher. In the first experiment, a group was given lottery tickets in sealed envelopes, and before opening their envelope, they were given the opportunity to switch envelopes with another member of their group. As an incentive to encourage members to switch envelopes, those who switched were given a pen.

In the second group, the members were given lottery tickets and were able to see their numbers right away. This group was also given a chance to swap tickets with one another and receive a pen. The people in this group were much less likely to trade their tickets. Why would this be?

The authors of the paper suggested that, according to the expected utility theory, every person should be willing to trade because the value of the pen exceeds the transaction cost of trading their ticket. However, in the group where the participants saw their tickets before they were given the opportunity to trade tickets and receive a pen, the subjects were able to anticipate possible regret that would occur if the ticket they traded away was selected.

The pioneers of behavioral economics were very aware of the importance and impact of regret aversion. In fact, in Michael Lewis’s book, The Undoing Project, he talks about how Kahneman played with the idea for a while about how people making decisions aren’t actually trying to maximize their returns, but minimize regret.

Now let’s turn to the regret aversion bias’s impact on finance and investing:

The biggest problem with regret aversion when it comes to investing is that it often results in an error of omission in which an investor fails to make a decision because they are paralyzed by their desire to avoid future regret. For example, if an investment appreciates quickly to an investor’s price target, an investor with regret aversion may fail to sell the security because it would be painful for them to sell and then see the stock go on to rally even more.

Due to the desire to avoid future regret, investors may hold winners too long. On the flip side, if an investment falls and no longer appears to be a good investment, an investor with regret aversion may keep holding onto the investment because they would “kick themselves” if they sold the security and then it went on turn around and rally.

These two scenarios both highlight the fact that regret aversion can cause investors to fail to make timely decisions, and as a result, can hold sub-optimal portfolios.

Another example of how regret aversion can lead to a suboptimal portfolio is when regret averse investors are overly conservative with investing. This may especially be the case in scenarios where an investor has previously experienced major losses in their investments. Such investors may fail to invest in any risky assets because they know there is a potential for loss, and if the investment were to go poorly, they would regret it. This manifestation of regret aversion is closely tied to loss aversion.

In the same way that regret aversion can cause an investor to hold on to winners and losers too long, it can also cause an investor to avoid investing in contrarian ideas, even if the investment thesis is sound. Often, the best opportunity for an investor is to buy an investment after a recent price decline. It may be very difficult for an investor with regret aversion to do this because they will almost certainly think “What if I buy this investment and it keeps going down?”

This example highlights the fact that regret averse investors would much rather follow the trend and be wrong with a crowd, rather than going out on a limb and being the only one who is wrong. Losses are much more tolerable if “everyone else” was also wrong, because then it is easy to shift the blame for the poor investment onto “unforeseeable factors.” If everyone got it wrong, there must be a bigger factor at play that was impossible to predict. This desire for comfort in the crowd may also result in a regret averse investor only wanting to invest in the biggest and highest quality companies, even if there are good opportunities in small caps or other, less followed securities.

To get a better understanding of this bias, let’s look at a hypothetical investor with regret aversion, and let’s walk through how they may have reacted to the SNAP IPO that took place earlier this year:

An investor may want to invest in SNAP because of all of the publicity surrounding the IPO. The investor has the fear of “missing out” on returns that “everyone else” will be getting, so they decide to invest in the IPO.

After investing in SNAP at $17 and watching it rise to $27, the investor considers selling because she believes the fair value is closer to $20. However, the investor fears of missing out on the future potential gains if SNAP turns out to be the next Facebook, so she does nothing.

SNAP has now fallen from a high of $27 to $15, and after reexamining the recent user growth and financials, the investor now believes that the fair value for SNAP is close to $10.  With SNAP trading at $15, it would make sense for this investor to sell her shares before they fall more. However, she has already experienced losses, and she thinks there is a slim possibility that SNAP could rebound, and she would really hate to miss out if that were to happen. As a result, she decides to do nothing and continues to hold the investment.

These examples probably sound very familiar to many of you, because regret aversion is a very common bias. In fact, the Nobel Prize winner and father of modern portfolio theory, Harry Markowitz, even admitted to struggling with regret aversion. He admitted that his portfolio contained 50% stocks and 50% bonds, and his reasoning was: “I visualized my grief if the stock market went way up and I wasn’t in—or it went way down and I was completely in it. My intention was to minimize my future regret.”

Markowitz knew if he held all stocks and the stock market crashed, he would regret it. But if he held all bonds and the stock market rallied, he would also regret it. To satisfy his bias, he went on to split his money evenly between the two asset classes. Even the founder of modern portfolio theory gave into his behavioral bias instead of using modern portfolio theory to build an “efficient” portfolio!

Regret aversion is one of the biases that is relatively easy to identify. Look for investors who have trouble selling winners or losers out of fear that they will “miss out” on future returns. Look for investors who are constantly keeping track of how past investments or investment options they did not choose are performing.

The Lirio Finance* Behavioral Risk Survey includes questions that can help an advisor determine whether or not an investor shows signs of having regret aversion.

Regret aversion is an emotional bias, so it may be difficult to correct, but there are a few things that can be done to help improve investor outcomes.

If an investor struggles with holding on to winners and losers for too long, it is important for the advisor to help the investor set price targets and remain disciplined throughout the investment process. Having an investment process in place will make it more difficult for the investor to hold onto a security just because they don’t want to miss out.

If an investor invests too conservatively due to the fear of regretting future losses, it is important to educate them about the importance of diversification. Explain how, although conservative assets reduce the risk of loss, they also greatly reduce the potential for capital appreciation, and will likely reduce their probability of achieving future financial goals.

If an investor struggles with “following the herd,” it is important to educate them that herd mentality is what often leads to bubbles. It is much more important to base investment decisions on solid research, even if that leads to investing in contrarian ideas.

As is the case for most emotional biases, creating an investment plan that helps to remove all emotion from the decision-making process is typically the most effective way to deal with emotional biases like regret aversion.

If you have questions about the regret aversion bias, or want to share other examples, tweet us @Lirio_LLC, #LirioFinance.*

For additional podcasts, subscribe on iTunes.

 

Find Lirio Finance online at Lirio.co/Finance. Follow us on TwitterLinkedIn, and Facebook.*

* Updated to reflect new Lirio Finance branding.

The thoughts and opinions expressed in this podcast are solely those of the person speaking.

The opinions expressed are as of the date of this podcast and may change as subsequent conditions vary. This podcast is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this podcast is at the sole discretion of the listener.

© Lirio, LLC