Regret aversion

Regret aversion is the tendency to make decisions that minimize the pain of possible future regret, even if those decisions are suboptimal. You hold a losing stock because selling it would mean regretting the original purchase. You sell a winning stock prematurely because holding it longer creates the risk of regret if it falls. The fear of regret guides decisions more than expected value.

The two types of regret

Action regret. “I sold that stock and it went up 100%. I regret selling.” This is painful.

Inaction regret. “I did not buy that stock and it went up 100%. I regret not buying.” This is also painful, but often less so.

Interestingly, people feel action regret more acutely than inaction regret for the same magnitude of loss. This asymmetry drives the disposition effect: selling a winner creates the risk of action regret if it goes higher. Holding a loser creates inaction regret, but a weaker form.

Regret aversion in practice

Holding losers. An investor bought a stock at $100 and it fell to $60. Selling it locks in the regret of having made a bad decision. But holding it preserves hope that the bad decision will be validated. Regret aversion makes her hold.

Selling winners too early. An investor bought a stock at $50 and it rose to $100. She considers holding to $150, but worries: “What if it falls back to $80? Then I will regret not selling at $100.” So she sells at $100. Regret aversion made her miss the potential gain.

Avoiding risky investments. An investor is considering a diversified portfolio with 60% stocks. But she thinks: “If the stock market crashes 40%, I will regret being that aggressive.” So she holds 40% stocks. Regret aversion — specifically, regret over potential losses — leads to underdiversification.

Regret aversion and reference points

Regret is keyed to a reference point. If you sold at $100 and the stock rises to $150, you regret not having held. But if you never bought the stock, you do not regret its rise — there is no reference point to feel loss relative to.

This suggests that regret is partly about identity: you see yourself as “someone who bought that stock and sold too early.” This identity makes the regret acute.

Regret aversion and FOMO

FOMO (fear of missing out) is the flip side of regret aversion. Fear that you will regret not having bought (inaction regret) drives you to buy. Fear that you will regret having sold (action regret) drives you to hold. Together, these regret-aversion forces can paralyze good decision-making.

Regret aversion vs. regret theory

Regret aversion is an emotional response to the thought of possible regret. Regret theory is a decision theory that incorporates regret as a factor in expected utility. The theory says people weight outcomes partly by the regret they would feel. This is more sophisticated than pure loss aversion.

Defenses against regret aversion

• Calculate actual regret costs. If you sell a stock at $100 and it rises to $150, your regret is real but your wealth is not harmed. You still made $100 on the original investment. Calculate the actual financial cost vs. the emotional regret.
• Use a rule-based system. If selling is determined by a rule (“sell if it rises 100% or if fundamentals deteriorate”), then selling is not a choice subject to regret aversion. The rule decided; you merely executed.
• Accept that regret is necessary. In investing, some regret is inevitable. You will sell winners that rise further. You will hold losers that fall further. The path to good returns requires tolerating regret.
• Focus on the process, not the outcome. If your process (based on fundamentals and valuation) was sound, you should not regret the outcome, even if it was bad. Separating process quality from outcome quality reduces regret.
• Track foregone opportunities and avoided disasters. When you sell a winner, note the stocks you sold to avoid (or sold instead). Track how those would have performed. Similarly, track the losers you avoided by taking a different action. Over time, you will see that avoiding regret cost less than embracing it cost.

See also