Updated: Jan 11, 2021
Regret aversion deals with a fear of an unfavorable outcome, oftentimes leading to inaction. FOMO is the ‘fear of missing out’ on a favorable outcome, oftentimes spurring rash action.
Both can impact your risk profile (not to mention, the returns in your portfolio).
A group of elders at a hospice were once asked at the end of their lives what they remembered the most about life. The researchers were caught off guard by their answer: it was what they hadn’t done – not their achievements that they remembered most. It was the places they had not traveled, the relationships they had not pursued, and the jobs they did not take that was on their minds. It turns out that regret shapes our minds and lives in many different ways.
Regret Aversion vs. FOMO
Let’s apply this to personal finance. Imagine you have a friend who has been dabbling in the markets for the past few months and he exclaims to you how he and others have doubled their money so quickly. Being the great friend he is, he provides you a nice tip on an upcoming IPO. Do you take the tip? The cognitive bias of regret aversion is when a person making a decision, anticipates regret and proceeds with the option that has the least possible regret.
A famous type of regret aversion is FOMO or the fear of missing out on something (which would cause regret) and therefore compels action. These are nudges of your judgment and could lead to decisions that may not be the most optimal.
The concept of regret aversion could have you ignore the tip incorporating how you would feel if the IPO was a total dud and it went straight down in a line. Or, FOMO could kick in and have you taking on excessive risk because you don’t want to miss out on potential returns.
Think of an example where a young adult has to decide whether to invest extra disposable income into the stock market for retirement, or spend that money on a lavish vacation with friends in a foreign country. If the vacation with friends is chosen due to visualizing regret about missing good memories (aka FOMO of missing the trip), and not properly weighing the value of investing early and letting money grow, then this may be a sub-optimal decision.
Another example is when deciding to wait for a market pullback to add a lump-sum investment of cash, or to buy at current prices. If an investor anticipates regret of buying a short-term market top, the investor may choose to wait for a decline.
This is not optimal because market timing is not optimal and can have negative consequences.
Regret aversion deals with a fear of a not so favorable outcome leading to inaction. Say you are out with your friends one night and see a beautiful lady at a bar. You start getting butterflies in your stomach and every part of you wants to go up and start a conversation with her.
However, you start thinking back on when you were rejected in the past and how you felt a little sour after that experience. Regret aversion would cause you to think about how you would regret having those similar feelings arise and you end up not approaching her.
Regret aversion has many ramifications within investing. It can impact your risk profile and the returns you generate in your portfolio.
Let’s Face It
Going back to the stock tip on the IPO, if that worked out, that could lead you to take higher risks going forward and lower risks if it didn’t work out. However that is not the optimal and rational thing to do. The best course of action is consistently think about each decision on its own accord and in relation to your goals and long-term investment objectives.
Once you realize and accept that regret aversion impacts the way we make decisions, you can take steps to account for it. Two key steps are writing down your investment plan and developing risk parameters.
Michael Pompian talks about regret aversion in his book Behavioral Finance and Wealth Management – How to Build Optimal Portfolios That Account for Investor Biases. He showcases how “herding behavior” is a result of regret aversion.
When a large group of people converge and buy into the same investment, this limits the future regret because others are with you on the investment idea. By writing down a plan, one can make sure investment mistakes like this and others do not occur.
The second step is to develop risk parameters.
Kahneman and Tversky created Prospect Theory to showcase “contradictions in human behavior.” For example, a person can switch between risk-aversion and risk-behavior in everyday scenarios. Kahneman says, “people may drive across town to save $5 on a $15 calculator but not drive across town to save $5 on a $125 coat.”
Investing is a hard game and you can’t navigate it without having some rules. You need to make sure that any of your shortcomings – yes, yours – cause you to make a decision that’s not in congruence with your rational long-term plan.
Another aspect of regret aversion is to have the data support you. Your friends will continue to give you those tips, but having a data verified system that backtests the strategy you are using, will help to make sure you do not lose your cool. Investing is not only about the markets but also about yourself. In essence, getting a grasp on this concept will help you trade better. You won’t regret it.
ETFication™ is here to arm you with tools to tackle investing yourself, including information on the cognitive biases you will face as an investor. By becoming aware of behavioral biases similar to regret aversion, you can shepherd your portfolio to long term safety.
Achieving your long-term goals involves becoming educated (at least a little bit). The investment industry is filled with tactics to confuse your decision-making analysis. Let ETFication™ help empower you to take control of your finances and create a portfolio that works for you.
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