What is Regret Theory

Regret theory states that people anticipate regret if they make a wrong choice and they take this anticipation into consideration when making decisions. Fear of regret can play a significant role in dissuading someone from taking an action or motivating a person to take an action.

BREAKING DOWN Regret Theory

When investing, regret theory can either make investors risk averse or it can motivate them to take greater risks. For example, suppose that an investor buys stock in a small growth company based only on a friend's personal 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 will ask questions and research any stocks that his friend recommends.

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 will be less risk averse and will likely buy any stocks that his friend recommends in the future without conducting any background research of his own.

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. (To learn more, see: The Importance of Trading Psychology and Discipline.)

Regret Theory and 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. (For further reading, see: The Pros And Cons Of Automated Trading Systems.)