Regret theory underscores that people anticipate regret if they make the wrong choice. This anticipation weighs heavily on their decision-making processes, either by dissuading them from taking action or prompting them to act. The apprehension of regret can significantly influence an investor’s behavior, potentially impairing their ability to make sound investment decisions.
Key Takeaways
- Regret Theory: Refers to the behavior driven by the anticipation of regret from making the wrong choice.
- Impact: This fear can hinder a person’s rational behavior, affecting their capacity to make beneficial decisions.
- Investor Behavior: Investors may become overly risk-averse or take excessive risks based on regret anticipation.
- Market Dynamics: During prolonged bull markets, some investors might ignore warning signs of a crash due to regret theory.
- Automation: Automating the investment process can help investors mitigate the fear of regret over making poor decisions.
Understanding Regret Theory
In the context of investing, regret theory can influence investors towards being overly risk-averse or encouraging them to adopt higher risks. For instance, an investor might buy stock in a small growth company solely based on a friend’s tip. If after six months the stock drops to 50% of its initial price, the investor might sell and realize a loss. To avoid future regret, they may decide to research recommendations more thoroughly or disregard tips from that friend altogether.
Conversely, if the investor didn’t act on the friend’s recommendation and the stock price increased by 50%, the investor might subsequently adopt a less risk-averse stance, buying stocks on mere recommendations without adequate research due to the fear of missing out.
Regret Theory and Psychology
Investors can reduce the impact of anticipated regret by understanding its psychological underpinnings. Reflecting on how regret has influenced past investment decisions allows investors to make more informed choices. For example, if an investor regrets missing major market moves and subsequently invests mostly in momentum stocks, it’s crucial to recognize this pattern before deciding on the next investment opportunity.
Regret Theory and Market Crashes
The fear of missing out, intertwined with regret theory, often surfaces during extended bull markets marked by rising prices and investor optimism. This fear can even drive conservative investors to overlook warning signs of an impending market crash. The concept of ‘irrational exuberance’, popularized by former Federal Reserve Chair Alan Greenspan, vividly illustrates how excessive enthusiasm can inflate asset prices beyond their fundamental values.
Investors might then mistakenly believe that recent price rises will persist, leading to heavy investments, the formation of asset bubbles, and subsequent market crashes. Historical examples include the 1929 stock market crash, the crash of 1987, the dotcom bubble burst in 2001, and the financial crisis of 2007-08.
Regret Theory and the Investment Process
Automating investment decisions can mitigate the fear of regret. Strategies like formula investing, which adhere to predefined rules for investments, minimize the discretionary decision-making process regarding what and when to buy. Using algorithms for trade execution and management further reduces the influence of past investment outcomes on current decisions.
Investors can backtest automated trading strategies to identify personal biases that might influence their decision rules. The growing popularity of robo-advisors also highlights the trend towards automated and low-cost investment solutions.
Related Terms: FOMO, Behavioral Finance, Automated Trading, Investment Strategy.
References
- Diecidue Enrico and Somasundaram Jeeva. “Regret Theory: A New Foundation”. Journal of Economic Theory, vol. 172, November 2017, pp. 88-119.
- The Federal Reserve Board. “Remarks by Chairman Alan Greenspan, The Challenge of Central Banking in a Democratic Society”.
- Morningstar. “2023 Robo-Advisor Landscape”. Pages 29-30.
- Grand View Research. “Robo Advisory Market Size, Share & Trends Analysis Report By Type (Pure Robo Advisors, Hybrid Robo Advisors), By Provider, By Service Type, By End-use, By Region, And Segment Forecasts, 2022 - 2030”.
