Regret Aversion Bias
In order to be successful at investing, an investor not only needs to have mastery over their numbers, but they also need to have mastery over their emotions as well. In the past few articles, we have already discussed how emotional biases can lead to suboptimal performance in investing. In this article, we will try to understand the regret aversion bias, which is another important bias that obscures the thinking of the investors and gets them to make wrong decisions.
The details of regret aversion bias have been listed further in this article.
What is Regret Aversion?
An investor is said to be suffering from regret aversion bias when he/she refuses to make any decision because of the fear that the decision will turn out to be wrong and then may later lead to feelings of regret. The emotional process behind this pretty simple. Regret causes emotional pain. Hence, the brain tries to avoid making decisions that cause regret.
It is important to understand that investors can make two different types of errors. On the one hand, they can make a decision which turns out to be wrong. This can be called an error of commission because some action has been committed by the investor. On the other hand, an investor can simply miss out on a great opportunity by not taking any decision. This can be called an error of omission because of the lack of any action from the investor.
In financial terms, an investor may be likely to lose the same amount of money either by commission or by omission. However, when it comes to psychological terms, the commission error has a much higher chance of inducing regret. This is because regret is usually associated with a responsibility for an action taken. This is the reason that in case of regret aversion, no action becomes the default response of the buyer.
Can Regret Aversion be Positive?
Regret aversion need not always be negative. In some cases, these biases may help investors from making wrong decisions. For example, if a buyer has already lost money by investing in an overheated market, the regret aversion will prevent them from investing in peaking markets the next time. This might actually help them avoid some losses.
Regret Aversion vs. Loss Aversion
Loss aversion and regret aversion may sound to be similar. However, in reality, they are quite different. Investors who are loss averse do not have problems making decisions. They just tend to make the wrong decisions because of emotional factors. On the other hand, regret aversion is a paralyzing fear because of which the investor is not able to make any decision. The likely outcome of loss aversion is a wrong decision, whereas the likely outcome of regret aversion is no decision at all! People with regret aversion always avoid taking any risks. They are known for choosing the safest path. On the other hand, people with loss aversion hate losses and may sometimes take excessive risks to turn their losses into profits.
How Regret Aversion Impacts Behaviour
Risk aversion causes investors to behave in some typical ways. The details of these ways have been mentioned below:
- Herding Effect: People who experience a lot of regrets are often not sure of their own decisions. This is the reason that they try to find validation in the decisions made by others. When their decision matches with the crowd, they feel that the potential for future regret has been minimized.
- Preference for Blue Chip Stocks: Regret aversion causes people to choose famous stocks like blue-chip stocks. Investors experiencing regret aversion are afraid of taking personal responsibility by investing in stocks that are not well known to the general public. These investors will never be able to pick up a stock early and gain from its upside because of their regret aversion.
- Conservatism: Many investors who experience regret aversion want to simply avoid risky investments. Instead, they are happy choosing investments that provide lesser returns because of the safety involved. In the long run, this could lead to underperformance and sub-optimal outcomes for the investor.
How to Avoid Regret Aversion?
The real problem with risk aversion is that it causes people to invest too conservatively. Hence, investors need to be aware of this bias and take appropriate investing decisions. A couple of strategies to help do so have been listed below:
- Diversification: Regret aversion bias basically revolves around risk avoidance. However, in order to avoid risk, it is not necessary to avoid equity as an asset class altogether. It has already been ascertained that the risk involved in equity investments can be reduced by diversification. Hence, when an investor who is affected by the regret aversion psychology creates a diversified portfolio, they can reduce the cognitive dissonance that they face.
- Long Term View: Secondly, it is important for equity investors to have a long-term view of their investments. This means that the investors should keep in mind that a well-diversified equity portfolio is fairly safe and provides decent returns in the long run. This will help them overcome their regret aversion.
The bottom line is that regret aversion, like other psychological biases, can be dealt with. People who have more control over their regret aversion tendencies have a higher chance of being successful in the stock market.
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- Behavioral Finance - An Introduction
- Heuristics and their role in Finance
- Advantages of Behavioral Finance
- Limitations of Behavioral Finance
- FAQs About Behavioral Finance
- Prospect Theory
- How Loss Aversion Affects Investment Decisions
- The Sunk Cost Fallacy
- The Endowment Effect
- Regret Aversion Bias
- Self-Control Bias
- Anchoring Bias in Behavioural Finance
- Confirmation Bias in Behavioral Finance
- Herd Mentality Bias
- Mental Accounting
- Recency Bias
- Overconfidence Bias
- Conservatism Bias
- Framing Bias
- Behavioral Portfolios
- Hindsight Bias
- Illusion of Control Bias
- Status Quo Bias
- Sample Size Neglect
- Optimism Bias
- Cognitive Dissonance Bias
- Home Country Bias
- Availability Bias in Behavioural Investing
- The Bias Blind Spot
- The Narrative Fallacy
- The Planning Fallacy
- Base Rate Fallacy
- Contrarian Investing
- Cultural Influences on Financial Decisions
- Behavioral Life Cycle Theory
- The Barnewall Model
- Bielard, Biel and Kaiser (BBK) Model
- Three Dimensional Pscychographic Model
- Categorizing Behavioral Biases
- Lessons Learned in Behavioural Finance