Regret Theory

Regret Theory states that individuals preemptively experience the feeling of regret or remorse while making all or some of their future decisions due to one or more wrong decisions made in the past. This causes them to make haphazard choices driven by the fear of experiencing regret in the future.

This phenomenon is commonly observed among investors and traders in stock markets. When an investor makes a wrong investment decision, they regret it. This feeling resurfaces every time they consider making investment decisions in the future. Such regret can rob an investor of their capability to make the right decisions since they continue to dwell on regrets associated with previous outcomes.

• Regret Theory states that individuals develop a fear-driven mindset upon experiencing a loss due to an incorrect decision they made in the past.
• It applies to investors and traders operating in stock markets and highlights how an individual's rational thinking abilities take a backseat in such cases.
• Regret may affect an individual’s future decisions to varying degrees because they develop a fear of anticipated or imagined losses.
• While regret theory focuses on the fear of anticipated losses, prospect theory outlines the idea of investors making decisions with a reference point in view.

Regret theory in investment refers to the unrelenting feeling of regret an investor experiences due to a single incorrect or untimely decision. This sabotages their decision-making skills. In the stock market, when a trader makes a mistake and incurs a loss, it is obvious that they will feel immediate and deep regret. However, the major downside, as observed in regret theory behavioral finance, is that a single instance of such regret becomes a powerful but negative driving force in an investor’s mind when they make other crucial decisions.

The theory further states that the feelings of regret induced by certain mistakes, particularly in stock markets where large amounts of money are involved, hold immense control over an individual. A small mistake has the power to stop an investor from making decisions in the future, irrespective of whether they will be proven right.

Since an investor will remember past mistakes and dwell on associated regrets while making future decisions, they will, in all likelihood, avoid making decisions, postpone them, or find alternatives. This is commonly observed in stock markets when investors face monetary losses. For instance, an investor may choose a different or new investment strategy, which may not entirely suit their risk appetite or financial goals, to avoid losses imagined on account of anticipated regret.

The theory also explains that even if the chances of experiencing regret in the same form or manner are low, investors feel uneasy about anticipated regret. Hence, they prefer to ignore the positive or upbeat possibility that it may not happen again. Due to this behavior, an investor’s capacity to think rationally significantly diminishes, and they end up avoiding the investment or letting go of a potentially lucrative chance or profit-making opportunity.

Apart from investing, the regret theory psychology can be observed in other areas, too, including human resources, marketing, healthcare, etc. For example, employee retention numbers may be an area depicting disappointing results for human resources managers.

Let us consider the following instances to understand the concept even better:

Example #1

Suppose Evelyn is a conservative investor. She fears experimenting with new stocks, even when they show good potential for high returns. She only invests in blue chip stocks due to the safety they offer.

Recently, the investor came across a new stock. She is considering investing in it in addition to her monthly blue-chip investments. Evelyn takes a bold step and invests in this stock. Unfortunately, its price declined, and she suffers a loss. Evelyn is filled with regret for the wrong decision she made.

A month later, Evelyn's friend Julia tells her about another stock showing significant promise. Julia plans to invest in it after a comprehensive fundamental analysis. However, Evelyn does not invest this time as she anticipates regret and prefers to stay in the safe zone.

Though Julia shared the necessary information with Evelyn to convince her to invest, Evelyn did not invest, dwelling on past regret. In this case, regret turned Evelyn into an even more risk-averse investor than before. She also lost her ability to make rational decisions based on solid logic.

Example #2

Suppose Nimble SunGrid is a software development company in Texas. James, a senior manager at the company, came across a significant investment opportunity while attending a conference for disruptive technology. He weighed the pros and cons of this investment. However, James could not shake off the regret he felt about his last investment decision made several years ago when he headed a project to revolutionize software development to attract more clients.

James had undertaken a software upgrade and improvement project that needed considerable investment in terms of monetary, technological, and human resources. However, the project had failed due to implementation issues at client sites. Later, James could not onboard any new clients due to the low success rate. Hence, the company suffered losses.

Today, the company has more money and many competent people to drive projects of various types and scales. Hence, James could have easily considered this new investment based on his company's existing financial position and his team’s current skills. However, since the previous event impacted James’ critical thinking abilities, he could not gather the courage to venture out this time and invest in this new opportunity. This shows that people affected by regret and paralyzed by fear lose sight of the bigger picture.

The implications of regret theory are listed below.

1. Investors tend to become more risk-averse than they were before when they anticipate future losses. It means they not only feel distressed about past mistakes but also experience undue tension about potential mistakes in the future.
2. The psychological impact restricts investors from taking advantage of high potential returns. They also do not prefer to time the market or capitalize upon lucrative opportunities, even when they have the tools and skills needed to do so.
3. If feelings of regret are not addressed early, investors can become negative while making decisions. They might react emotionally to every situation and become the voice of doom.
4. It takes away an investor’s critical thinking abilities and jeopardizes rational behavior. This might be accompanied by frustration and panic.
5. Investors blame themselves for past mistakes and become wary of making decisions, even when there is adequate proof that their choices are likely to prove wise in the future.
6. Investors who have borne losses overanalyze even the most insignificant investment decisions.
7. In the worst-case scenario, an investor may even prefer to stop investing altogether.

To overcome regret theory psychology, one can follow the tips and pointers given below.

1. Investors should stay focused and keep their investment goals in view when making decisions. This can help them avoid emotional bias.
2. Taking calculated risks, even small ones, is recommended instead of becoming entirely risk-averse.
3. Investors should prioritize rational behavior and critical thinking before letting regret take control of their emotions and drive them into a frenzy.
4. When one learns that mistakes are part of every process, the possibility of acting on impulse or fear declines.
5. If investors are able to acknowledge the fact that overthinking does not help, they might be able to see that they are scared of an event that may not happen or repeat.
6. Emotions may hamper an individual’s cognitive abilities. Hence, a balance is necessary. Financial decisions should be based on logical reasoning, fundamental analysis, and market movements while checking one’s emotions only to strengthen these decisions.
7. Investors or traders should consider the big picture and build a long-term vision, keeping their risk appetite and financial goals in mind.

Both theories deal with decision-making mindset and approach. Here are the differences between regret and prospect theory.

This article has been a guide to what is Regret Theory. Here, we explain its examples, differences with prospect theory, implications, and how to overcome it. You may also find some useful articles here –

• Disposition Effect
• Winner’s Curse
• Loss Aversion Bias