Regret Avoidance

What Is Regret Avoidance?

Regret avoidance (also known as regret aversion) is a theory used to explain the tendency of investors to refuse to admit that a poor investment decision was made. Risk avoidance can lead investors to hang on to poor investments too long or to continue adding money in hopes that the situation will turn around and losses can be recovered, thus avoiding feelings of regret. The resulting behavior is sometimes called escalation of commitment.

Understanding Regret Avoidance

Regret avoidance is when a person wastes time, energy, or money in order to avoid feeling regret over an initial decision. The resources spent to ensure that the initial investment was not wasted can exceed the value of that investment. One example is buying a bad car, then spending more money on repairs than the original cost of the car, rather than admit that a mistake was made and that you should have just bought a different car.

Regret Avoidance During the Housing Crisis

During the 2008 housing crisis, many recent homebuyers refused to walk away from their mortgages, despite the fact that their property values had dropped so far that they were not worth the mortgage payments. Research in 2010 found that property values had to drop below 75% of the remaining money owed before homeowners considered walking away. If decisions had been based solely on rational economic factors, many owners would have walked away sooner. Instead, emotional attachment to the homes, combined with an aversion to seeing money previously spent amount to nothing, caused them to delay walking away.

Behavioral Finance and Regret Avoidance

The field of behavioral finance focuses on why people make irrational financial decisions. Regret avoidance is an example of irrational behavior. Money is invested or spent based on sentiment and emotion, rather than by a rational decision-making process. Investors who display this type of behavior value money spent in the past more highly than money spent in the future to recover the previous investment.

Regret aversion can also lead to the sunk-cost fallacy. People fall into the sunk cost trap when they base their decisions on past behaviors and a desire to not lose the time or money they have already invested, instead of cutting their losses and making the decision that would give them the best outcome going forward. Many investors are reluctant to admit, even to themselves, that they have made a bad investment. Changing strategies is viewed, perhaps only subconsciously, as admitting failure - which leads to regret. As a result, many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile.

The “Concorde Fallacy” Example of Regret Avoidance

Another example of regret avoidance is known as the “Concorde Fallacy.” The British and French governments continued to pour money into the development of the Concorde airplane long after it became apparent that there was no longer an economic justification for it. The politicians involved did not want to deal with the embarrassment of pulling the plug and admitting that the money already spent would not result in a functioning vehicle. The resulting vehicle, and the money spent developing it, is almost universally regarded as a commercial failure.

Preventing Regret Avoidance

Having a basic understanding of behavioral finance, developing a strong portfolio plan, and understanding your risk tolerance and reasons for it can limit the probability of engaging in destructive regret avoidance behavior.

Set trading rules that never change. For example, if a stock trade loses 7% of its value, exit the position. If the stock rises above a certain level, set a trailing stop that will lock in gains if the trade loses a certain amount of gains. Make these levels unbreakable rules and don't trade on emotion. 

Investors can also automate their trading strategies and use algorithms for execution and trade management. Using rules-based trading strategies reduces the chance of an investor making a discretionary decision based on a previous investment outcome. Investors can also backtest automated trading strategies, which could alert them to personal bias errors when they were designing their investment rules. Robo-advisors have gained in popularity among some investors as they offer access to automated investing combined with a low-cost alternative to traditional advisors.

Regret Aversion and Market Crashes

In investing, regret theory and the fear of missing out (often abbreviated as "FOMO") frequently go hand in hand. This is particularly evident during times of extended bull markets when the prices of financial securities rise and investor optimism remains high. The fear of missing out on an opportunity to earn profits can drive even the most conservative and risk-averse investor to ignore warning signs of an impending crash.

Irrational exuberance — a phrase famously used by former Federal Reserve Chair Alan Greenspan — refers to this excessive investor enthusiasm that pushes asset prices higher than can be justified by the asset's underlying fundamentals. This unwarranted economic optimism can lead to a self-perpetuating pattern of investment behavior. Investors begin to believe that the recent rise in prices predicts the future and they continue to invest heavily. Asset bubbles form, which ultimately burst, leading to panic selling. This scenario can be followed by a severe economic downturn or recession. Examples of this include the stock market crash of 1929, the stock market crash of 1987, the dotcom crash of 2001, and the financial crisis of 2007-08.

Frequently Asked Questions

 What is regret aversion?

Regret aversion is when a person wastes time, energy, or money in order to avoid feeling regret over an initial decision that can exceed the value of the investment. One example is buying a bad car, then spending more money on repairs than the original cost of the car, rather than admit that a mistake was made and that you should have just bought a different car. Investors do the same by not making trades, or else holding on to losers for too long for fear of regret.

Does regret avoidance exist in the stock market?

Research shows that traders were 1.5 to 2 times more likely to sell a winning position too early and a losing position too late, all to avoid the regret of losing gains or losing the original cost basis.

How can one minimize regret avoidance?

Having a basic understanding of behavioral finance, developing a strong portfolio plan, and understanding your risk tolerance and reasons for it can limit the probability of engaging in destructive regret avoidance behavior.