Saturday, September 3, 2011

Regret Aversion Bias and investing...

People exhibiting regret aversion bias avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision making.

Regret aversion bias and the decision to sell...

Investor A: Wasup buddy? Howz the market treating you?
Investor B: I am completely out of it. Sensex fell from 18000 to 16000. Same thing happened in 2008 also. I thought it will bounce back again, so I didn’t get out at that time. And I regretted it heavily.
Investor A: But weren’t you bullish when the market was 18000? So at 16000, you should be more bullish right?
Investor B: Noooo man..I don’t want 2008 repeating. Better to get out now. I will see what to do when things stabilise.

Sounds familiar? Investor B sold his holdings, not because they were overvalued, but because he had experienced huge regret when he didn’t sell in 2008 and he did not want to have the same experience again. In order to avoid regret, Investor B has taken a blanket sell decision, which is not a ‘studied’ decision and may prove to be very wrong. Then why did he take this decision?

His thought process..

Please click to enlarge

So basically, what Investor B says is that an opportunity loss is preferable to an actual loss! Hence, the decision to sell will cause him minimum regret. That’s why the decision to sell is the best decision to take. But was that the best decision? He may have sold some really undervalued stocks too, just to avoid regret!
How does it affect investors: Regret aversion bias thus makes investors take irrational and panic selling decisions, which are not well thought out.
What should one do about it: I sincerely believe that, especially, decisions to sell should be taken solely on the merits (or demerits) of that particular stock. Trying to time the market is the worst possible way to take sell decisions.

The other side of the coin.. Regret aversion bias and the decision to buy

Scenario 1: You are looking to buy a stock. You bought it, but after buying it, suppose the price goes down. Will you regret your decision to buy?
Scenario 2: You are looking to buy a stock. But you decide not to buy it, and after that, the price goes up. Will you regret your decision not to buy?

Of course, you will experience regret in both scenarios. The question is, in which scenario will you experience more regret? Sooo, given a choice, which scenario will you prefer? Majority of us will prefer scenario 2 (come-on, be honest!), where there is no actual loss, hence lesser regret!

How does this affect investors: on this side of the coin, regret aversion bias makes investors numb. When the market falls and stock prices are going down, this bias stops investors from buying and lapping up the undervalued stocks, for fear that they may fall further! When the time comes to be aggressive, regret aversion sets in and causes indecisiveness in investors.
So what to do?
I too get affected by this bias and coupled with my ‘conservative’ (a.k.a. fattu) attitude, I incur lotssss of opportunity losses. But typically, here is what I do..
  • Do not think about results of past actions while taking present decisions.
  •  Study each company you are looking at very well. If possible, write down your reasons for buying/selling or not buying/not selling on a piece of paper. When you write things down, your mind will not cook up excuses later!
  • Concentrate on the particular stock/company and ignore overall sentiment. If you think its undervalued, then buy. Period. If you think its crazily undervalued, then buy like crazy! Sureeee, the stock may (rather, will) go down after you buy. Accept it and make peace with it. Your portfolio will not show positive returns every day. So don’t be afraid to see paper losses, if your study has been in depth and you have the conviction.
The market gives us opportunities all the time. In bullish times, opportunities to sell are more than those to buy.. and vice versa during bearish times. Take advantage of these opportunities and be at peace!!

Cheers and happy investing...

P.S. For those of you writing in to know my views on 'where the market will go', please refer to this post.


Rohan said...

Hi Neeraj, Very well put up post about an investor's bias. I had bought GE ship @ 300 levels in recent past and thought that was low, Lol markets took them for as low as 220. during those levels i should have reacted decisively and bought more but again my mind convincing me of the bitter experience of the past i did not react.!

Anonymous said...

WOW ! Thank you for an excellent post as usual. Very lucid explanation.

I guess to master this one needs Zen like detachment from the ups and downs of the markets.


Anonymous said...

Nice post. But when market falls, cheap stocks becomes cheaper. What to do then? And what's your take on Resolution-1 of this link-

Neeraj Marathe said...

Hello Rohan,
Yes it happens to all of us :-)

Thnx Rahul, glad u liked the post.. and ya, certain amount of detachment is necessary..though i dont think it shud be zen-like :-)

Dear Anonymous,
I too am a big fan of the Prof..what he says makes sense in a way..however, each one of us have our own way of doing things. Plus, I do not think the Prof means to say that one shud TOTALLY ignore equity beyond certain valuation levels of the nifty. there exists value at all times in some corner of the mkt..i personally prefer to be more stock specific, rather than look at the index or its valuations..

Robin Thomas said...

If it werent for these biases, then investing would have become the game of IQ. The higher the IQ the better he/she is at investing.

hitesh said...

great post neeraj. Exactly the sentiments a retail investor goes through during market downturns. And the paralysis setting in once markets correct to levels when actually one should be buying is a phenomenon which is often seen. Most often people tend to be guided by past experiences while investing and for most investors the fall of 08-09 is still fresh in the memory.

Best way out is as suggested by you to concentrate on chosen few stocks rather than look at market levels.

Neeraj Marathe said...

Thnx Hitesh,
U do fantastic work urslf..we really shud interact more..

Neeraj Marathe said...

Hi Robin,
I agree! BUT, as u urslf said, its not so! higher IQ does not automatically mean higher returns..