Life experiences teach us to avoid, as far as possible, any regrettable decisions. We all know what regret feels like: it’s an unpleasant feeling and it’s understandable that we’d do anything to avoid it.
Imagine you buy a lottery ticket every week and always pick the identical sequence of numbers. One week, you decide to try some different numbers. To your dismay, your standard sequence of numbers win that week; the one week you didn’t pick those numbers! This is when that unpleasant feeling starts seeping in. Even though both sets of numbers had an equal probability of winning, you’d feel the regret of not going with the other.
So: avoiding regret influences the decisions we make.
In 1988, William Samuelson and Richard Zeckhauser discussed an example of this phenomenon. They created the scenario of a parent who needs to go to the shop and has a baby asleep in its crib at home. A parent would never consider leaving their sleeping baby alone at home while they quickly went to the shops. In the improbable likelihood that the baby would be killed in a fire, the parent would feel extreme guilt and regret. However, such parents would hardly hesitate to take the baby with them in the car, albeit the risk of an accident in the car being of a much higher magnitude than a house on fire. The associated guilt of a car accident would be substantially less, however.
Avoiding regret pushes us to conform to social norms or the status quo. When it comes to investments, shares in particular, this anticipated regret can be a dangerous emotion. Probably the most irrational form thereof is avoiding selling shares at a loss.
Evidence shows us that when people sell shares, they tend to sell those that have made them a profit (winners) rather than those that have made them a loss (losers). Why is that? Is it the pride or satisfaction of having had a share that made you some profits? Surely there was a chance the share price would’ve kept on rising? Rationally, when deciding to sell shares, you should be selling those that you believe will perform less well in the future. But this isn’t what happens; people generally sell winners and keep losers in order to avoid the feeling of… you guessed it, regret.
I know, I know, “buy low, sell high”… I’ll explain more next month.
Author: Gizelle Willows CA(SA) MCom Finance is Senior Lecturer in Financial Reporting at the University of Cape Town