A few days ago, He Knows No Fear won the 2.30 at Leopardstown at a price of 300/1. Do you regret not backing it? Probably not. Most of you don’t bet on obscure Irish horse races and those of you who do know better than to back rank outsiders as these are usually overpriced. And indeed, the biggest bet Corals took on was a £2.50 each-way punt.
If you’d put £10,000 into Games Workshop five years ago you would have over £150,000 by now. Do you regret missing out? I suspect more of you do, but not many. Games Workshop probably wasn’t on your radar then, and if you had been interested in smaller retailers you might as easily bought Debenhams instead.
Do you regret not selling equities in February? I suspect even more of you do. But perhaps you shouldn’t. Although there were some warning signs (high price-money ratios and an inverted yield curve a few weeks earlier) there were also reasons for optimism such as the decent dividend yield.
These three examples tell us something about the nature of regret. How much of it we feel depends upon the counterfactual – what we might reasonably have otherwise done. The more obvious the counterfactual, the more the regret. Backing rank outsiders in low-grade race meetings is not something most of us normally do, so missing out on that 300/1 shot is no cause for regret. But accepting a job offer that you in fact turned down is a plausible counterfactual and so is a source of regret.
We should therefore regret underperforming the market because the alternative – holding a tracker fund – is a reasonable counterfactual. Equally, losing money after being fully invested in equities should also be reason for regret because there is also the obvious counterfactual of holding some cash.
Regret is a powerful emotion. It’s understandable that you might want to base your investments upon wanting to minimise it.
It might even be wise to do so. Alexander Muermann at the University of Pennsylvania shows that wanting to reduce regret causes investors to “hedge away from extremes” and to have reasonably balanced portfolios. This can be a good thing because, as Victor DeMiguel and colleagues at London Business School have shown portfolios that are equally balanced between assets can do as well as more sophisticated forms of diversification.
Better still, minimising regret can lead us to focus on eliminating tail risk – the small chance of disaster. Which is why we buy insurance even if it is overpriced from a purely actuarial point of view. If you are hiring somebody to pilot a plane or run a nuclear power station, you want a man obsessed with minimising regret.
But, but, but. Wanting to reduce regret can also lead us astray.
One way in which this can happen has been uncovered by research by Christoph Merkle at Aarhus University. He found that UK investors who had suffered big losses during the 2008-09 financial crisis were much less upset than they had expected to be. A big reason for this is that they comforted themselves with the thought that everybody else was in the same boat, so they had no reason to blame themselves.
This tells us that one way to reduce regret is to do the same as others – to herd. This needn’t be a bad thing: it can cause us to buy tracker funds. But it can also cause us to follow the herd by buying into bubbles for fear of missing out. And because more people buy at the top of bubbles than at the start of them, this leads us into big losses.
Wanting to minimise regret can cause us to lose money in another way – by chasing losses. We are often reluctant to sell a losing stock because doing so would cause us to regret buying it. But holding on in the hope of getting even exposes us to downside momentum effect, which means a good chance of losing even more.
In fact, trying to reduce regret can lead us into outright self deception. The psychologist Leon Festinger studied a group of Americans who believed that the world would end on December 21 1954. He found that when it did not do so the group inferred not that they had been as daft as brushes, but that their god had had a last-minute change of mind. Of course, few of us go this far. But we have lots of ways of persuading ourselves that our earlier decisions were right. This can cause us to persist with errors – backing losing stocks or buying overpriced ones such as smaller speculative stocks – and to fail to learn from our mistakes.
There are, therefore, dangers in trying to reduce regret.
Perhaps instead we should regard it as an inevitable part of life. We’ve all missed out on countless opportunities and made bad choices in investments, jobs and life simply because inattention, ignorance and irrationality are ineliminable features of human nature. Edith Piaf was surely wrong – and certainly atypical – when she sang “je ne regretted rien.” The upside of this sad fact is that regret gives us the stimulus to learn from our mistakes. If we fail to look honestly at those choices, however, we’ll not learn.
