What is regret aversion? According to Stephen Horan, Robert R. Johnson and Thomas Robinson, the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors," it is a behavioral finance principle that can produce bad investing decisions.
They say it is also “a psychological theory that posits that some people have regrets when they see that their decisions turn out to be wrong even if they appeared correct with the information available to them at the time they made the decision. In the context of investing, regret aversion is based on the desire of investors to avoid experiencing painful regret as a result of bad investment decisions.”
There are regrets of omission and regrets of commission. A regret of omission is over an action that was not taken, while a regret of commission is over an action that was taken.
Regrets of omission
The authors began by reminding readers of Warren Buffett (Trades, Portfolio)’s baseball analogy, in which he compares investing to a being at bat in a game with no called strikes or balls. Investors can let thousands of pitches go by before swinging at one they like.
That analogy helps explain why the legendary value investors profiled in chapter 12 were willing to hold large cash positions when they did not see stock valuations that met their criteria. They managed their regret aversion. Most famously, Buffett shut down his Buffett Limited Partnership in 1969 because he could not find good value stocks. This was a time when the “Nifty 50” stocks were trading at “astronomical” price-earnings multiples.
Would you suffer regret if you held a large position in cash as the market was advancing all around you, as Buffett did during the late 1990s? Could you have stuck to cash when other investors were seemingly getting rich with the then-burgeoning technology stocks? The authors followed up this question: “Do you have the psychological makeup to stick to your value investing convictions, or would you capitulate and follow the herd?”
For value investors, there is another factor to consider. Those whose regret gets too high may switch to a growth strategy; however, when they do that, they generally do it late in the cycle. They miss the big gains from the growth period and once the market reverses, they miss the opportunities available to value investors.
If you’ve wondered why most individuals fail to match index averages, the authors explain that this is the reason. You need to have the patience to stick to your investing style across market cycles, the authors wrote, “the patient investors are the ones that are handsomely rewarded.”
Regrets of commission
Turning to regrets of commission, the authors point to investors who did not sell losing stocks because they reasoned they would not have a real loss until they sold the stocks. It’s more emotionally satisfying to sell a winning stock because there is a gain to be celebrated.
As the old saying goes, “You can’t go broke by taking a profit,” True, but that ignores potential tax consequences. For those investing outside a tax-sheltered plan, selling at a loss allows investors to take a capital loss and that can be used to offset gains in other stocks and lower taxes.
Making mistakes is always a part of investing and, as we saw in chapter 12, all the iconic investors made them too. In a valuable insight, the authors argued that just because a stock’s price went down, it does not mean you made a mistake. If the stock was undervalued, then it just became an even better opportunity.
A real mistake, they say, occurs when you realize there was something wrong with your analysis, which may have been changing circumstances or that a company’s problems were greater than you expected. For example, when an investor discovers a company’s losses from derivatives were higher than initially thought.
Successful value investors try to assess their degree of regret aversion. That’s important because, according to the authors, “Trying to follow an investment style that is inconsistent with your psychological character is destined to fail. It is better that you recognize your emotional biases and build a strategy that is consistent with them rather than fight them. Be true to yourself is an axiom worth following in the investment arena.”
Conclusion
Regret aversion is a powerful part of investing because it affects our decisions, or lack thereof. It stems from the disappointment that comes from making a choice that later turned out to be wrong, even though it seemed correct at the time it was made.
Regrets of omission are about decisions not made and can affect our ability to hold cash rather than buy overvalued stocks. Regrets of commission are about decisions made and may affect, among other things, sticking with losing stocks for too long.
Finally, it’s important that we try to figure out our own levels of regret aversion; in doing so, we are helping ourselves choose an investing style that fits our psychological profile.
Read more here:
- Strategic Value Investing: Patience Pays Off
- Strategic Value Investing: Bill Miller
- Strategic Value Investing: Weitz and BrandesÂ
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