Monday, July 6, 2009

Why Investors Do What They Do: Regret

One of the basic assumptions in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret.

Regret is a math problem believe it or not and has long been discussed as component of statistical gathering. In her book "The Nature and Growth of Modern Mathematics" Edna Ernestine Kramer suggests that by using Professor Leonard Savage's regret matrix, something she defines as "the difference between the actual payoff" as a result of "some pure strategy and the payoff he might have received" had the test subject known for example, what could have happened.

As an integral part of decision theory, Savage's 1951 study of the subject was not the first. Blaise Pascal may have been when he proposed his wager. Nor was it the last. Investors have a tendency to look for benchmarks. Mutual funds use benchmarks to tout their investment prowess. And the probability that doing either of these exercises as being worthwhile is debatable.

Investing, no matter how lonely that decision you make seems, is always a competitive one. Failing to realize that your decision's success needs to have taken into account how other people doing the same thing is often commonplace. Yet, this is often not decided based on any specific thought. You see where other folks are investing. If they flock, you flock. If they flee, you flee. Human nature actually and genetically wired for survival. And you make the decision on how to allocate based on what you fear most: risk.

But our big brains get in the way. This is where regret comes into the picture. Savage constructed a criterion he called the Minimax Regret. We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed.

This will result in a portfolio recovery period that will take you much longer to get back to even than someone who had not reacted or regretted their investment decisions. The market makers, those you placed your trust in, if blindly and unknowingly, made numerous wrong choices and everything fell in. The mutual funds that are used by you to achieve long-term gains have now repositioned their holdings to begin again in the aftermath of the last twelve months. Denying risk at this point (heading off to an index fund or worse, a target-dated fund) will not allow risk to play a role in your financial recovery.

Regret is a surprisingly destructive part of an investor's behaviors. Anticipating past history in making investment decisions allows regret (the "what if" is replaced with the "what if I don't") to strangle risk and not allow it to do the job it is supposed to do.

Next up: The media

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