Regret Theory: Meaning, Psychology, Applications

What Is Regret Theory?

Regret theory states that people anticipate regret if they make the wrong choice, and they consider this anticipation when making decisions. Fear of regret can play a significant role in dissuading someone from taking action or motivating a person to take action. Regret theory can impact an investor's rational behavior, impairing their ability to make investment decisions that would benefit them as opposed to harming them.

Understanding Regret Theory

When investing, regret theory can either make investors risk-averse, or it can motivate them to take higher risks. 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 and realizes a loss. To avoid this regret in the future, the investor could ask questions and research any stocks that the friend recommends. Or, the investor could decide to never take seriously any investment recommendation made by this friend, regardless of the investment fundamentals.

Conversely, suppose the investor didn't take the friend's recommendation to buy the stock, and the price increased by 50%. To avoid the regret of missing out, the investor could become less risk-averse and might likely buy any stocks that this friend recommends in the future without conducting any background research.

Regret Theory and Psychology

Investors can minimize the anticipation of regret influencing their investment decisions if they have an understanding and an awareness of the psychology of regret theory. Investors need to look at how regret has affected their investment decisions in the past and take that into account when considering a new opportunity.

For example, an investor may have missed a large trending move and has subsequently only traded momentum stocks to try to catch the next significant move. The investor should realize that he tends to regret missed opportunities and consider that before deciding to invest in the next trending stock.

Regret Theory 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.

Regret Theory and the Investment Process

Investors can reduce their fear of regret from making incorrect investment decisions by automating the investment process. A strategy like formula investing, which strictly follows prescribed rules for making investments, removes most of the decision-making process about what to buy, when to buy, and how much to buy.

Investors can 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.