What Is Regret Theory?
Let me explain regret theory to you directly: it's the idea that people like you and me anticipate feeling regret if we make the wrong choice, and we factor that anticipation into our decisions. This fear of regret can either stop you from taking action or push you to act when you might not otherwise. In investing, this can mess with your rational thinking, leading you to make choices that hurt rather than help your portfolio.
Key Takeaways
Regret theory centers on how humans behave when facing the fear of regret, which comes from anticipating a bad decision. This fear can disrupt your rational behavior, making it hard to choose options that benefit you instead of those that cause harm. For investors, it can lead to being too cautious with risks or taking unnecessary ones. In long bull markets, it pushes some to keep investing heavily while ignoring crash signals. You can cut down on this fear by automating your investment process, which helps avoid mistakes from poor decisions.
Understanding Regret Theory
When you're investing, regret theory can make you either avoid risks altogether or dive into higher ones. Take this example: suppose you buy stock in a small growth company just because a friend recommended it. Six months later, it drops to half the price you paid, so you sell at a loss. To dodge that regret next time, you might start questioning and researching any stocks your friend suggests, or you could decide to ignore their recommendations entirely, no matter the fundamentals.
On the flip side, if you skipped the friend's tip and the stock rose 50%, you might feel the regret of missing out. To avoid that, you could become less risk-averse and start buying whatever your friend recommends without any research.
Regret Theory and Psychology
You can minimize how anticipated regret affects your investment choices by understanding the psychology behind regret theory. Look back at how regret has influenced your past decisions and factor that in when eyeing a new opportunity. For instance, if you've missed a big market move before and then chased momentum stocks to catch the next one, recognize that pattern of regretting missed chances before jumping into another trending stock.
Regret Theory and Market Crashes
In investing, regret theory often pairs with the fear of missing out, or FOMO, especially in prolonged bull markets where prices climb and optimism runs high. This fear can push even the most conservative investor like you to overlook signs of an upcoming crash just to grab potential profits. Think of 'irrational exuberance,' a term from former Fed Chair Alan Greenspan—it describes excessive enthusiasm that inflates asset prices beyond their real value.
This optimism creates a cycle where you believe recent price rises will continue, so you keep investing heavily. Bubbles form and eventually burst, sparking panic selling and possibly a recession. Historical cases include the 1929 stock crash, 1987's Black Monday, the 2001 dotcom bust, and the 2007-08 financial crisis.
Regret Theory and the Investment Process
You can lessen your fear of regret from bad investment calls by automating the process. Strategies like formula investing follow strict rules for what, when, and how much to buy, stripping away most discretionary choices. Automate your trading with algorithms for execution and management—this cuts down on decisions swayed by past outcomes. Backtesting these strategies can reveal any personal biases in your rules. Robo-advisors are popular now, offering automated investing at a low cost compared to traditional advisors.
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