Regrettable Choices

"It isn't the burdens of today that drive men mad. Rather it is regret over yesterday or fear of tomorrow." -Robert J. Hastings

Equity investing requires the ability to price uncertainty. But at what emotional costs? Having to live with a poor outcome or the knowledge of a missed opportunity makes all people want to kick themselves. If left unchecked, these feelings influence investment decisions in unintended fashions.

Coulda, Woulda, Shoulda

Regret is the emotion experienced when confronted by a mistake, especially one for which we feel responsible and if we can easily imagine better options. It springs from poor results and foregone opportunities. The consequences can be as severe as the man who killed himself when, after years of playing a number in the lottery, he neglected to renew his multi-week ticket, and missed the winning draw for 2 million pounds.

Thankfully regret is not usually fatal. But it causes pain. Pain can etch vivid memories into our brain. Avoiding such feelings then becomes a powerful motivator for decisions we make called "regret aversion."

Small Gains and Large Losses

Regret aversion has also been tied to a well known investment behavior. The Disposition Effect is a behavioral theory formulated by Hersh Shefrin and Meir Statman. This theory suggests that investors are more likely or disposed to sell their winners and hold onto losers. The underlying motivations for these behaviors are commonly attributed to being risk averse with gains (taking certain profits quickly) and risk seeking with losses (preferring to ride them out in hope of eventually breaking even).

Shefrin and Statman identified regret aversion as a fundamental motivator for The Disposition Effect. Under this view, selling winners prematurely reflects the desire to avoid the regret of having a stock run up in price only to watch it come all the way back down again — round-tripping. Similarly, holding on to losing positions can be an aversion to the regret associated with feeling like a loser once a "paper loss" is realized. Avoiding painful or unpleasant feelings is a universal defense mechanism. Understanding one's tendency to experience regret aversion can help in making the right risk/return trade-offs.

Not Adding Up

Investors are much more likely to add to or make incremental investments in portfolio positions that are down rather than up. This behavior is at odds with the time-honored adage "starve your losers and feed your winners." It is, however, consistent with what we know about Prospect Theory which suggests investors tend to be more risk seeking with losses and risk averse with gains.

Not adding to winners is also explained by regret aversion. In his paper "Are Investors Reluctant to Sell Their Losses?" Terrance Odean suggests that not buying more of a portfolio winner may reflect the manager's regret over not having purchased more of it initially. Thus, in order to avoid the regret of admitting the mistake of purchasing too little, the manager avoids adding to the position despite the belief that the stock will only continue to outperform. When the initial buy is significantly less than the average full position weight, such regret aversion can sacrifice significant alpha.

More Than A Feeling

"Regret aversion is a negative cognitive experience," according to researchers Marcel Zeelenberg and Rik Pieters. They go on to explain, "The reason it is cognitive [and not entirely emotional] is because it requires the ability to compare what might have happened to what actually did happen."

To better understand the effect of feedback on regret, they examined games of chance in the Netherlands. The National Lottery works like most others in that people buy a ticket based on numbers they choose. The people who become aware of winning numbers are typically those who bought tickets. Regret over not playing is experienced by few. The Postal Code Lottery is different. The number is your postal code — similar to a U.S. Zip Code except that it serves no more than 30 addresses. Your choice is to buy a ticket or not. If your postal code is the winning number then you very likely will learn both the winning number and who the winners are — your neighbors. The additional feedback about the foregone opportunity provided by the Postal Code Lottery produced greater levels of regret and regret aversion (i.e. participation).

Conclusion

Regret aversion is a powerful force. It can shape which positions are purchased and which are sold. Adds to existing positions are also affected by the desire to avoid regret. Feedback involving poor outcomes and foregone opportunities pushes our regret buttons. And this is the very type of information managers confront regularly. Developing regret aversion is natural. Learning to manage it can save you from regrettable performance.

References:
1. "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence", Journal of Finance, July 1985, by Hersh Shefrin, Meir Statman.
2. "Are Investors Reluctant to Sell Their Losses?", Journal of Finance, November 1998, by Terrance Odean.
3. "Consequences of regret aversion in real life: The case of the Dutch postcode lottery", Organizational Behavior and Human Decision Processes, March 2004, by Marcel Zeelenberg and Rik Pieters.