Regret Aversion

Mar 22, 2007: 7:35 AM CST

While no blog post can adequately address the realities and implications of “regret aversion,” I wanted to alert you to its existence and possible resources for learning more.

Simply stated, we feel regret and remorse more for actions we DID take than for actions we DID NOT take. One way to understand this is that we feel pain that comes from personal experiences, especially of loss (staggering losses in the market, for example) because we lived it, experienced it, and it affected us deeply. The negative feelings from this experience are often easily brought to memory and we tend to take actions to avoid these feelings in the future (when confronted with a decision that may result in similar pain).

On the contrary, it is difficult to internalize the feelings of missed opportunity to such a degree, because the regret from the missed experience is not felt as deeply. Such memories (for example “I saw a trade set-up and did not take it and if I did, I would have made $5,000”) are mostly generated, rather than experienced to the core of our being (such as “The trade set-up I just took cost me $5,000! because I violated my discipline!”). The experience did not touch as deeply and as such is easily forgotten with less pain.

When the time comes to make a new decision, the feelings of the actual loss resulting from the actual decision will appear more readily in our mind and emotions, and distort new information (through fear).

Regret aversion can take the form of action paralysis, where a trader cannot execute a trade because of the potential fear he or she remembers from prior experience. However, the experience can attack from the back as well. Once in a trade that has gone against your entry, you might hold the trade because you do not want the pain of yet another large loss. Another factor of mental accounting is that investors treat paper losses differently than real losses. It’s almost as though the loss does not materialize until we hit the sell (or buy to cover) button, yet the loss is still real.

Our previous experiences can PREVENT us from selling when we should and thus a small loss turns into yet another large loss and builds an additional layer on our regrets and negative experiences. One can imagine the bitter cycle that is created when our mind lures us to avoid our discipline or system and try to ‘reframe’ our situation to make us feel better.

For me, this was particularly true in that my initial experiences with loss kept me sidelined because I did not want to repeat the pain I felt. The lure of profits wasn’t enough to overcome the pain of losses – I’m sure this occurs with many new traders. I felt happier when I avoided losing money (through a potential trade idea I didn’t take) rather than the pain of “missed opportunity” which resulted from seeing the market move exactly as expected when I didn’t take a trade set-up I should have taken. Overshadowing the whole process was my previous experience which shaped me to value protecting my capital over growing my account.

You must be aware of your own responses and memories and apply behavioral techniques (later posts and resources) to reprogram this “regret aversion” response. What helped me was restructuring the natural association so that I hated the pain of missed opportunities over the pain of lost money – remember that you cannot control the outcome, but the process. I plan to elaborate more on this later.

In the meantime, for a plethora of academic resources on regret aversion, visit the resource at www.behaviouralfinance.net.

14 Comments

14 Responses to “Regret Aversion”

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    When studying this at uni i was surprised that a missed opportunity affects people more than the loss of money today.

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