Alfred Bernhard Nobel was born in Stockholm, Sweden in 1833. He was a chemist, engineer and an inventor and held 355 patents to his name. In 1867, while experimenting with explosives, he discovered a mixture that had high explosion capabilities and was easy to handle. He named the invention ‘dynamite’ after the Greek word ‘dynamo,’ which means power.
He set up huge factories to manufacture and supply the same and acquired a fortune as humanity used his invention for construction and war. In 1888, Alfred’s elder brother Ludvig died. The day after his death, Alfred was going through the newspapers to read the obituaries written for his brother. He realised that some newspapers had mistaken him to have died instead of his brother.
In one of the newspapers, the obituary started with the line ‘The Merchant of Death has died’. It condemned him for his invention of military explosives that led to so many deaths. Alfred was disappointed with what he read. It is widely believed that the moral regret that he felt about his invention, led him to donate bulk of his wealth to a fund which was to be distributed in the form of Nobel Peace Prize.
When we take a decision and it does not lead to a good outcome, we go into self-recrimination. We think about all the options that we should have chosen or ideas that had prompted us to avoid the option we chose. This emotion, commonly known as ‘regret’ is almost like inflicting punishment on ourselves. Clearly, we go to great lengths to counter this emotion as well as to avoid it. Regret and regret aversion both impact our decision making in personal life and in investing.
Regret – Norms and Styles
Consider two people Mr A and B: Mr A regularly prefers to invest in fixed income securities issued by high-quality companies. He has no investment in equity. Recently, as interest rates declined significantly, he bought some stocks, but they are currently below his purchase prices.
Mr B regularly invests in stocks. He bought some stocks recently, which are currently in the red.
Who feels more regret? Most people will point to Mr A. When people act out of character or outside their comfort zones, the regret is higher. New investors entering the equity market may suffer a loss and regret their decision. Their future decision on asset allocation will be impacted by this regret. The above situation can be considered in a different version of assets or styles too.
Imagine if Mr A is a regular investor in largecap
stocks and dabbles in smallcaps for the first time and loses. Mr B may not have much regret if he is a regular investor in smallcap stocks. Or consider Mr A and Mr B are portfolio managers following value investing and growth investing styles, respectively.
Now, replace the fixed income products in the above case with value stocks (for Mr A) and equities with growth stocks (for Mr B). The regret of moving away from value style to growth and taking a loss is likely to be very painful for Mr A.
Regret and Responsibility
Consider three people Mr A, Mr B and Mr C: Imagine that the equity markets have come off sharply. Mr A has a large amount of deposits maturing and has to renew them. He considers buying equities as he thinks the market will rebound. However, he nevertheless decides to renew his fixed deposits.
Mr B, who is heavily invested in equities and, on his own analysis, decides to sell equities and move into fixed deposits.
Mr C is in a similar situation like Mr B and transfers the money from equities to fixed deposits. The only difference in his case is that he does so under the advice of a financial consultant.
The stock market rebounds 15%. Who feels more regret? Hersh Sherfin, in his book
Beyond Greed and Fear, says, most people choose Mr B as having the most regret. Although all of them missed the market rally, Mr A continued with his default or conventional allocation. And inaction causes less regret than action (in the short term). Mr C was in the same situation as Mr B, but he is not completely responsible for this decision. He was advised by someone else. Ironically, taking the blame and reducing Mr C’s regret is an important service provided by his financial consultant. Mr B, of course, took the action to change and, that too, completely on his own. He feels the most pain. This is because, the pain of regret depends on the degree to which the person making the decision feels responsible.
Regret and Hindsight
Regret comes with a companion: Hindsight Bias. When we evaluate our decisions, we choose to compare the option we chose with the alternative that turned out to be the best choice in hindsight.
Let’s use a recent example: A lot of investors regret not investing some money in equities in March 2020 when the markets fell but, they continued their default investment in bonds, which yields 7% per annum. Nifty’s range in March 2020 was a high between 11,300 and 7,600. Of course, investing during market correction is generally profitable. However, when investors evaluate their decision, they compare their lost opportunity with the lowest Nifty level in March 2020 than anywhere in between, showing uncanny confidence in timing the market exactly (investing at 7,600) in hindsight.
Also, they will tend to under-appreciate even the most valid arguments that shaped their decision at that time.
There are many investors who identify certain areas of investment (stocks, sectors, industries, factors) as their strengths. These form a part of their circle of competence. To err in one’s circle of competence causes more regret than the one outside purely because in hindsight, one feels it seemed like an easy decision.
Regret Aversion and Risk Aversion
Because regret is a painful emotion, we do our best to try and avoid it. That leads to risk aversion.
Consider the Allais Paradox:
Choose between option A & option B in the following problem 1
- Option A: 20% chance to win Rs 400,000
- Option B: 25% chance to win Rs 300,000
Now choose between Option C & Option D in the following problem 2
- Option C: 80% chance to win Rs 400,000
- Option D: 100% chance to win Rs 300,000
Option A and Option C have superior expected value to their counterparts. One would expect a person choosing Option A in the first problem to choose Option C in the second. However, a lot of people who choose Option A in the first problem choose Option D in the second. This is mainly to avoid the regret of missing a sure Rs 300,000 in Problem 2.
Regret aversion makes people risk averse and stick to conventional ways. In a
Money magazine interview, Harry Markowitz, who won a Nobel Prize for developing the Modern Portfolio Theory (developing ideas to choose the right portfolio) was asked about his personal money allocation strategy. He replied: “My intention was to minimise my future regret. So, I split my contributions 50-50 between bonds and equities”.
The Netherlands Post Lottery is one of the best examples of decision making for regret aversion. Here, one buys a lottery ticket and there is a pin code on the ticket. The draw is not about a particular lottery number, but a pin code of the area. All the participants who bought the lottery in the winning pin code get a prize. The lottery was an instant success, because of regret aversion.
People imagined their regret if they did not buy the lottery and if their area code was selected and their neighbours won.
Managing Regret
Making decisions that are based on the regret of the previous decision can lead you into trouble. At the same time, we may make suboptimal choices to avoid future regret. The simple steps that can help manage regret are as follow: Draw up a good investment process, follow it with discipline and expect errors.
- Rules help reduce regret. Collecting these rules which work (most of the time) in generating good returns and putting them together in a proper lineup (stages or steps) is your investment process.
- Actions create more regret than inactions in the short term. Gilovich and Medvec have written an excellent research paper where they prove that in the long run, however, inaction creates more regret.
In the case of investments, when investors have a good process and the inaction of not following it with discipline can become the biggest regret. No investment strategy or style or process works 100% of the time.
Expect that there will be some decisions where you will not get the desired outcome. That should help reduce the regret.
As Shakespeare once said, “Let’s not burden our remembrance with a heaviness that’s gone.” Don’t let regret or regret aversion guide your actions (or inactions).
