DEFINITION of Regret Avoidance
Regret avoidance is a theory used to explain the tendency of investors to refuse to admit that a poor investment decision was made. Sometimes called the sunk-cost fallacy, risk avoidance can lead investors to hang on to poor investments too long or to continue adding money in hopes that the situation will turn around and losses can be recovered, thus avoiding feelings of regret. The resulting behavior is sometimes called escalation of commitment.
BREAKING DOWN Regret Avoidance
Regret avoidance is when a person wastes time, energy or money in order to avoid feeling regret over an initial decision. The resources spent to ensure that the initial investment was not wasted can exceed the value of that investment. One example is buying a bad car, then spending more money on repairs than the original cost of the car, rather than admit that a mistake was made and that you should have just bought a different car.
Regret Avoidance During the Housing Crisis
During the 2008 housing crisis, many recent homebuyers refused to walk away from their mortgages, despite the fact that their property values had dropped so far that they were not worth the mortgage payments. Research in 2010 found that property values had to drop below 75% of the remaining money owed before homeowners considered walking away. If decisions had been based solely on rational economic factors, many owners would have walked away sooner. Instead, emotional attachment to the homes, combined with an aversion to seeing money previously spent amount to nothing, caused them to delay walking away.
Behavioral Finance and Regret Avoidance
The field of behavioral finance focuses on why people make irrational financial decisions. Regret avoidance is an example of an irrational behavior. Money is invested or spent based on sentiment and emotion, rather than by a rational decision-making process. Investors who display this type of behavior value money spent in the past more highly than money spent in the future to recover the previous investment.
The “Concorde Fallacy” Example of Regret Avoidance
Another example of regret avoidance is known as the “Concorde Fallacy.” The British and French governments continued to pour money into the development of the Concorde airplane long after it became apparent that there was no longer an economic justification for it. The politicians involved did not want to deal with the embarrassment of pulling the plug and admitting that the money already spent would not result in a functioning vehicle. The resulting vehicle, and the money spent developing it, are almost universally regarded as a commercial failure.
Preventing Regret Avoidance Behavior
Having a basic understanding of behavioral finance, developing a strong portfolio plan and understanding your risk tolerance and reasons for it can limit the probability of engaging in destructive regret avoidance behavior.