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Regret Theory

Investors will feel regret if a wrong decision is made and will thereby consider this regret when making decisions

What is Regret Theory?

Regret theory, studied in behavioral finance, is a concept stating that investors will feel regret if a wrong decision is made and thus will consider this anticipated regret when making investment decisions.

Regret theory can adversely impact an investor’s rational behavior, such as dissuading them from acting or motivating them to act. As a result, regret theory can impair an investor’s ability to make decisions that would be beneficial.

 

Summary

  • Regret theory states that investors will feel regret if a wrong decision is made and will thereby consider this regret when making decisions.
  • Regret theory can alter an investor’s risk profile, causing them to be more risk-averse or risk-seeking than normal.
  • The fear of missing out is a byproduct of the regret theory.

 

Understanding Regret Theory

The fear of regret alters an investor’s risk profile, causing them to be more risk-averse or risk-seeking than they normally would be. For example:

 

Regret Theory Example: Being More Risk Seeking

Mike is a conservative investor who prefers to put his money into low beta stocks. Recently, he notices the meme stock craze that is unfolding in the financial markets, with numerous meme stocks surging by over 100%.

Mike further sees his colleagues purchasing meme stocks, and he decides to purchase some meme stocks himself, ignoring potential risks, to avoid the regret of not purchasing it if it runs up further.

 

Regret Theory Example: Being more Risk Adverse

Mike recently purchased a stock that caused him to incur losses even though he did adequate due diligence and research. To avoid the regret of losing money on further stock picks, Mike starts employing excessive caution and taking an abnormal amount of time to arrive at a conclusion for each investment decision.

 

Regret Theory: The Fear of Missing Out

The fear of missing out, also known as “FOMO,” is a byproduct of the regret theory. FOMO is used to describe a feeling of investor anxiety/regret that they are missing out on an exciting experience or important opportunity by not investing.

As a result, the investor would ignore their typical risk profile and buy into stocks (increasing their risk profile) for fear of missing out on a potential continued run-up in prices. FOMO can cause the most conservative and risk-averse investors to ignore warning signs of a bubble or imminent market crash.

 

Overcoming Regret Theory in Investing

Acknowledging and coming to terms with the fact that you are exhibiting signs of regret theory is a key first step. Investors can minimize regret theory in their investment decisions by following a disciplined and structured investment process called formula investing. Regarding trading execution and strategy, investors can automate their trading strategies and use algorithms for execution.

Due to the ease of access to the internet, sensational news headlines play a role in promoting a feeling of regret in investors. For example, there are numerous online articles from various publishers promoting stocks that offer significant upside and to buy/sell certain stocks. As such, it is imperative to filter out news that may be biased or subjective when considering an investment decision.

Overcoming regret theory involves staying as objective as possible when making investment decisions and to avoid sensational news headlines and emotional biases.

For example:

John primarily invests in the stock market by putting $5,000 at the end of each month into the SPDR S&P 500 Trust ETF. It is currently the middle of the month, and he reads on CNBC that numerous analysts expect a stellar earnings season.

As a result, John feels that it might be a better decision to put $5,000 into the SPDR S&P 500 Trust ETF now rather than wait for the end of the month to avoid the regret of missing a potential stock rally if earnings turn out to be strong.

To overcome regret theory, John should conduct objective research on whether analysts are correct in assuming a stellar earnings season. If he arrives at his own belief that an impressive earnings season is very likely to happen, he can consider investing now rather than later.

If he does not have a strong conviction, he should remain disciplined and continue putting $5,000 at the end of each month into the ETF regardless of the media commentary.

 

More Resources

Thank you for reading CFI’s guide to Regret Theory. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Algorithmic Trading
  • Hindsight Bias
  • Stock Market Crash
  • Behavioral Finance Course
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