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More Than Just Regret

Anchoring, loss aversion, and hindsight bias also often occur when clients suffer regret-aversion bias.

Michael M. Pompian, 11/15/2012

This month's article is the 14th in a series called "Managing Behavior in a Volatile Market" and Part I of a discussion on regret bias. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, is now available.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with regret bias. Fifty-six percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to regret bias (i.e., when poor decisions from the past and the fear of future poor decisions affect the investing process). Of that group, at least half of those people were also subject to the following six biases:

1. Anchoring (66%)
2. Loss Aversion (59%)
3. Hindsight (57%)
4. Representativeness (55%)
5. Recency (53%)
6. Self-Attribution (53%)

For example, of the respondents who said they were subject to regret bias, 66% of them were also subject to a question designed to identify anchoring bias, and so on for the other five biases.

Below, I will provide commentary on the first three of these biases: anchoring, loss aversion, and hindsight. I will discuss why these biases are likely linked with regret bias and what you can do to counsel a client who has these biases.

Regret and Anchoring
Regret and anchoring are naturally tied. As we know, those influenced by regret bias tend to avoid making decisions that will result in an investment action out of fear that the decision will turn out poorly. Anchoring occurs when investors cling to a given price level when called upon to make an investment decision.

Haven't we all, at one point or another, come across a situation where one makes an investment at a given price, say $100 per share, and it goes down due to poor fundamentals? However, we avoid making a sell decision because either we don't want to realize the loss (see next section) or we are anchored to the $100 price and will regret it later if the investment miraculously recovers and gets back to $100.   

Advice: When a client exhibits anchoring bias combined with regret, I recommend that advisors focus their client's attention not on the purchase price but rather the prospect of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action is to sell.

Regret and Loss Aversion
As noted in the last section, regret and loss aversion are also naturally tied. Regret can keep some investors out of a market that has recently generated sharp losses. Having experienced losses, our instincts tell us that to continue investing is not prudent. Yet periods of depressed prices may present great buying opportunities. Regret coupled with loss aversion can persuade us to stay out of the stock market just when the time is right for investing.

Advice: Counsel your clients that they will make investment mistakes. Everyone does (even you!). The best investors in the world make meaningful mistakes.

In today's market environment of extreme volatility, many clients are unable to take action because they don't want to see a new investment get driven down immediately. In these cases, I recommend that clients "average in" to the markets--taking three months or six months to get invested. This often puts the fear of losses aside: If an investment goes down, you can buy more at lower prices.

Regret and Hindsight
Regret and hindsight are connected; however, this may need some explanation. As we know, hindsight bias occurs when people reflect on past investment mistakes and believe that many could have been easily avoided. We want to think we are smart all the time and don't make mistakes; this bias perpetuates that myth.

As discussed, regret-aversion bias occurs when people avoid making decisions that will result in action out of fear that the decision will turn out poorly. Here again, people want to think they are always smart and avoid making decisions for fear they might make the wrong decision. 

Advice: My advice to those investors subject to regret and hindsight is to accept the fact that investment mistakes will occur. It happens to everyone! The important part is that a structured process is followed and discipline is actively pursued. 

Conclusion
Hopefully you have learned something about regret and the biases connected with it. When you encounter a client with regret bias, remember the examples you have read about in this article. It might help to build a better client relationship! In next month's article, we will review the second three biases associated with regret. 

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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