Regret Aversion Bias – Oh! I made a mistake


Regret Aversion

A theory that says people anticipate regret if they make a wrong choice, and take this anticipation into consideration when making decisions. Fear of regret can play a large role in dissuading or motivating someone to do something.

For example, suppose that an investor buys stock in a small growth company based only on a friend’s recommendation. After six months, the stock falls to 50% of the purchase price, so the investor sells the stock at a loss. To avoid this regret in the future, the investor will ask questions and research any stocks that his friend recommends.

Conversely, say the investor didn’t take the friend’s recommendation to buy the stock, but the price increased by 50% rather than decreasing. Thus, to avoid the regret of missing out, the investor will be less risk averse and buy any stocks that his friend recommends in the future.

http://www.investopedia.com/terms/r/regrettheory.asp

People who are caught by this bias tend to avoid taking decisive actions because they fear that, in hindsight, the decision taken by them may be proved wrong.
Scenario 1: You bought a stock, and you see the price falls by 50%
Scenario 2: You wanted to buy a stock, but, did not buy yet, and you see the price rises by 50%
In both scenarios the investor will have regret in hindsight, but, in scenario 1 the regret is more as there is an actual loss of money.
For most of us, the pain of regret is far more than the pleasure of winning.

Regret Aversion Bias in Investing

  1. Investors think irrationally and make wrong decisions in buying and selling their investments
  2. An investor may wait for a stock to break a price point to buy. But, the price may not move up, and hence he invests the money elsewhere. Few days later the price breaks the point and moves up by 20%. The investor is left in regret.
  3. Investors do not sell their profitable positions due to the fear that they might forgo the upside potential.
  4. Choosing fixed income products, just to avoid regret investing in the stock market and risking the investment.
  5. Most investors usually regret not buying into the markets, during a recessionary period.
  6. Investing in only large cap companies, and later regretting to see several mid and small caps giving multi bagger returns.
  7. Selling the winners so soon, at a small profit, regretting the decision after seeing the sold stocks’ prices soar several times.
  8. You buy a stock just based on a recommendation from a friend, and it goes up and you make handsome gains. Then the next time, you tend to take any recommendation from your friend. Instead, if the price falls and you suffer losses, you tend to analyse any of your friends recommendation.

Overcoming Regret Aversion

  1. Proper budgeting, and financial planning, and goals
  2. Understanding clearly your risk taking ability, followed by appropriate asset allocation.
  3. Taking help with un-biased analysts, friends and financial planners.
  4. Having a proper approach and strategy in investing – both buying and selling.
  5. Do not think about results of past decisions while taking present decisions.

My Experience

  1. During my early days of investing, I used to invest heavily in ETFs, and Index funds, then I moved to large caps and then once I had some confidence in my analysis, I started investing in midcaps and small caps.
  2. I invested in Axis Bank in 2009 for approx. Rs.631, and I sold it in early 2010 when it was around Rs.990. The stock all the way rallied up and crossed Rs.1400. Sure, I regretted the decision of selling to early.
  3. I followed Nestle for a long time and wanted to buy. When it traded around 1400+ levels during 2008-09, a very attractive price with margin of safety. I wanted to wait for the stock to fall down further, but, it started moving up. I did not want to chase the upside and waited. But, it never came down and we all know where it is trading today. Of course, I regret even today for not buying in 2009.
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Filed under Behavioural Finance

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