Countering regret-aversion bias

Chas Craig, BridgeTower Media Newswires

 Regular readers of this column know behavioral finance topics feature prominently because learning about cognitive errors and emotional biases, eliminating them where possible and accommodating them where they are not, can be an investment edge.

Cognitive errors (e.g., illusion of control bias, hindsight bias and confirmation bias) are primarily due to faulty reasoning and can often be corrected or mitigated with better training. Emotional biases are not related to conscious thought and stem from feeling, impulses or intuition. Therefore, while cognitive errors are important, since emotional biases are harder to coach out of our humanity, it behooves us to acknowledge their presence, and structure investment processes designed to neuter them. While philosophies can be adopted in the abstract, the specific processes used must be customized to the individual, given we all have a unique psychological makeup.

Recent columns explored ways to counter the loss aversion, overconfidence, status quo and endowment biases in an investment process. Today we continue a series on emotional biases as defined by Kaplan. Below the definition of the bias, I offer ideas on how to structure an investment process to mitigate its impact.

Regret-aversion bias occurs when market participants do nothing out of excess fear that actions could be wrong. They attach undue weight to actions of commission (do something) and do not consider actions of omission (do nothing). Their sense of regret and pain is stronger for acts of commission.

Regret-aversion bias is closely related to the previously discussed ambiguity bias cognitive error, said another way, analysis paralysis. The proposed remedy for countering the ambiguity bias in the prior column was to demand wide margins of safety since endlessly analyzing a company is not practical.

Consider an investor who follows a policy of requiring draconian margins of safety before purchasing a stock position. Consequently, it is likely that she will only own a few individual stocks. This could be consciously viewed as a feature, not a bug. Something unique about a stock portfolio managed this way relative to an actively managed mutual fund, as one example, is that most of one’s security analysis time would be spent evaluating companies that will never be owned. Operating this way would result in a lot of errors of omission. Peace would have to be made with this fact, which could be seen as just as much or more about happy living as about sound investment.

Continuing the example used in the previous column regarding countering the overconfidence bias, if an investor were to use diversified funds to fill out 80% of an equity allocation, he could strategically overweight towards what he views as the most relatively attractive geographies, market cap groups, styles and sectors. Roughly 80% of the exposures of most professionally managed pools of capital, such as an actively managed diversified mutual fund, are likely implicitly the market “betas” the manager chooses or is mandated to have. By simply making these beta exposures explicit, the investor may be able to save a lot of time which could be used to comb more desert for attractive individual stock opportunities.

In the prior columns for this series on countering emotional biases, the examples provided arguably resulted in structuring the investment process around biases in a way that resulted in more rational and objective decision making. This may still be true here, but in the example above, the connection between the process and rationality/ objectivity is less direct, for the remedy offered up here is just as much or more about mental well-being as sound investment. However, a healthy mental state provides fertile ground for rational and objective analysis.


Chas Craig is president of Meliora Capital in Tulsa (