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Finance From A to Z: Week 18 (R)

Finance From A to Z: Week 18 (R)

With a nearly constant stream of exciting developments within the financial world as there are nowadays, Fear of Missing Out—oftentimes referred to as FOMO— has become a common, yet unwelcome feeling amongst investors.

Indeed, FOMO generally has a negative impact on the decision making processes that drive investments, compelling investors to act based on compulsion rather than logic. In this week’s issue, we’ll be taking a look at a close relative of FOMO, termed Fear of Regret, which suggests that the decisions driving investments can also be influenced by the anticipation of, for lack of a better word, regret from making the wrong choice! 

So, R stands for Regret Theory!

What Is Regret Theory?

In behavioral finance, regret theory is a concept stating that investors will feel regret when a wrong decision is made and will thus incorporate this anticipated regret in their choice, their desire to eliminate or reduce this possibility when making investment decisions.

Not only may regret theory hinder an investor's capacity to make intelligent decisions, but it can also have a negative impact on their ability to make logical choices, leading them to become excessively risk-averse or encouraged to take risks they shouldn't. However, the individual investor may very well do better in the long term by comprehending the role that regret theory serves within investment.

Regret Theory and Investing

Regret theory is particularly pertinent during prolonged bull markets, when some investors continue to make large investments despite warning signals of an oncoming disaster out of concern that they could lose out on a chance to make money.

Even the most cautious and risk-averse investors give in to a fear of regret when the prices of financial instruments increase and investor excitement is strong. How can an investor stop this from happening, then?

One of the most important first steps to reversing the detrimental consequences of the regret theory is to accept and come to grips with the reality that you are displaying them.

If investors understand and are aware of the psychology of regret theory, in addition to adhering to a disciplined and structured investment process known as formula investing—a strategy that follows a set of prescribed rules for making investments, removing the majority of the decision-making process about what, when, and how much to buy—investors can minimize the anticipation of regret influencing their investment decisions.

Therefore, overcoming regret theory essentially demands avoiding spectacular news headlines, emotional biases, and remaining as objective as possible when making investing decisions.

Applications of Regret Theory

To better understand why some bubbles emerge and burst, regret theory can be applied to market behaviors. For instance, when investors keep making large investments because they start to think that the recent rise in prices indicates what will happen in the future.

Asset bubbles develop, eventually bust, and cause panic selling. This behavior has not only been widely noted in the 1929 stock market crash, but also in the 2001 dotcom crash and the 2007–2008 financial crisis.

That’s all for this week’s article. Thank you for reading!

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