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Thursday 6 August 2009


Behavioural Biases (4): Regret

If you’ve ever done something and then regretted it you’re in the fine company of the rest of the human race. If you’ve never regretted anything then you’re probably a sociopath and need to stop attacking people with spatulas and get a nice quiet hobby instead. Something like misdirecting people into buying stupid stocks on internet bulletin boards should do nicely.

If you are fairly normal, however, you’ll be aware that regret is an unpleasant and queasy feeling which you’d generally rather avoid if at all possible. As ever, when it comes to finance, obeying the urgings of your intestines comes at a cost. In investment it pays it to pays to regret nothing: although it’s certainly true that pride comes before a fall in your portfolio value.

Avoiding Regret

It makes perfectly rational sense in most walks of life to avoid situations that give rise to feelings of regret. Swapping lottery numbers and then seeing the sequence you’ve chosen for the last five years come up would be a horrible feeling although, rationally, the two sets of numbers are equally likely. Of course, rationally, you should never buy lottery tickets at all.

However, when it comes to stocks and shares regret is a terribly dangerous emotion because our attempts to avoid suffering from it lead us to do financially stupid things. Amongst the most irrational is to avoid selling shares at a loss. This happens frequently when people need to sell, for one reason or another. This may be to buy some other super future performer or simply to raise cash for another venture. The evidence strongly suggests that when people do sell their shares they overwhelmingly prefer to sell those that have made them a profit rather than those that are trading at a loss.

Rationally, the best basis for choosing which shares to buy should be to sell those you believe will perform less well in the future rather than those that are selling below some buying price anchoring value. But, no, people will sell winners and keep losers in order to avoid the feeling of regret that comes from making a duff investment. Such a trade also allows them the satisfaction of pride from having had a winner, an equally irrational response, especially as the damn things will usually carry on going up.

The Disposition Effect

Psychologists call this the disposition effect. It was beautifully illustrated in a study by Ferris, Haugen and Makhija in 1988 who showed that stocks which had had gains had higher transaction volume than those that had had losses: people were hanging onto their losers and trading away their winners. Further work by Terence Odean indicated that investors were 50% more likely to sell a winner than a loser and that the outperforming stocks that investors were selling went on to outperform over the rest of the year in which the trade was carried out.

The disposition effect is really a partial statement of something we’ve seen before – loss aversion, the unwillingness of investors and golfers to face up to a loss. However, regret takes us a step beyond this because it shows that simple loss aversion has longer term effects. Even better – or worse – the disposition effect doesn’t just say that we’ll avoid selling our losers but also that we’ll preferentially sell our winners in order to avoid selling losers. The effect appears to be fairly constant across all sorts of investors – professional and amateur, experienced and otherwise although there’s some limited evidence from Dhar and Zhu that experience reduces the impact of regret on trading decisions.

Future Choice

However, the disposition effect has ramifications far beyond simple loss aversion. No, as Barber, Odean and Strahilevitz have shown, the impact of this continues after a sale of stock has been made. Investors’ feelings of regret or pride impact their subsequent decisions about trading in the same stock. So they will buy back stocks they have previously sold for a profit, but not for a loss, in an attempt to repeat the pleasurable feelings they got from the previous trade.

That’s not all. Investors will also buy back a stock that’s trading at a lower price than they previously sold it for but not a higher price. This is also a pleasurable experience and although avoiding buying companies that have done well since a sale may well be irrational it at least avoids needing to face further feelings of regret on that particular score.

Finally investors vastly prefer to buy more shares in companies they already own if the share price has declined, but not if it’s gone up. This process of “averaging down” increases the potential for future pleasure and reduces possible future regret as the reference average buying price of the stock is reduced.

None of these strategies improves portfolio performance, of course. Quite the opposite according to the researchers.

Emotions and Counterfactuals

Regret is, of course, an emotion. Psychologists, in the main, would much rather we didn’t have emotions since they tend to get in the way of nice logical laboratory experiments and are neurologically difficult to isolate, to boot. Barberis and Xiong have argued that emotions are actually the drivers behind the disposition effect and that it’s not the fact that a stock is held at a loss or a profit that’s the issue but the fact that the investor made a choice to buy it in the first place. It’s choice, and that the choice could have been otherwise, that triggers regret and the attempts to avoid it.

So regret seems to arise from human calculations of counterfactuals – mental simulations of alternative scenarios. The easier it is to visualise a (happy) alternative the more regret is induced. That’s why burning your ex-lover’s belongings and then the home you once shared makes emotional sense, although sticking pins in a voodoo doll while screaming profanities is a less expensive alternative, I’ve generally found.

Counterfactuals are easily accessible to investors as they study their on-line portfolio valuations: usually they’re handily highlighted in soothing blue or jarring red. It’s this calculation of counterfactual choices that may be behind the repurchase of stocks that have lost value and the avoidance of stocks that have gained value, however irrational this may be in valuation terms.

The effect is significant – the repurchase of previously sold stocks accounts for upwards of 10% of all stocks bought by investors in the study, so it’s not like this is a minor effect. It’s also clear that this isn’t the availability heuristic kicking in – people don’t simply buy back a stock because they’re aware of it. No, in order to buy it back it must be trading at a lower price than they sold it at.

Profiting From Irrationality

One final piece of research at least suggests a way that rational investors can make money out of the irrational attempts of others to avoid feelings of regret. A study by Nofsinger looked at how investors react to good and bad news about their companies. What he found was that good news caused share prices to rise but induced investors to sell while bad news caused prices to fall and investors to sit on their hands. This is entirely consistent with the disposition effect’s outcome of holding losers and selling winners.

This does at least suggest a trading strategy. The effect of good news was partially cancelled out by trigger happy investors “selling into strength”. More rational investors might, therefore, view such occurrences as an opportunity to acquire companies likely to perform well in the short term at a discount to a more efficient market’s clearing price.

After all, what’s the point in studying behavioural finance if you can’t make some money out of it?

Previous Article: Behavioural Biases (3): Loss Aversion

Next Article: Behavioural Biases (5): Anchoring


  1. yes. good things often happen more than once. ex: positive earnings surprises can be a profitable strategy because they tend to recur...not just a one time affair! same thing for bad. one bad report often leads to another!

  2. That was the investment process used by Jeremy Lang at Liontrust. It worked fine until it didn't any more. last year.

  3. Just to play devil's advocate, I'm not sure it's always bad per se to keep hold of a stock that's going down in price, or rebuying one you held before that's cheaper.

    Surely you bought it because you recognized value traits, and if the market hasn't then you wait until it has?

    Holding in the face of deteriorating a business case or the evaporation of whatever attracted you to it in the first place is a different thing of course.

  4. its all about BUY LOW and SELL HIGH
    Dont sell when its Low wait til its High again.