Terrance Odean on How Regret Drives Investor Behavior

If there’s one emotion that stands out as playing a major role in people’s investment behavior, it would be regret.

Terrance Odean, Rudd Family Foundation professor of finance at the Haas School of Business at the University of California, Berkeley, has been researching the impact of regret on the way people invest, in particular how regret—and the ways in which people try to manage it—conditions their behavior vis-à-vis the stock market.

His research through the years has shown, he says, that investors “seek to minimize the emotional experience of investing as much as they can,” and this tendency determines the ways in which they buy, hold and sell stock.

Case in point: In a recent study, the findings of which are yet to be released, Odean observed U.S. investors who went out into the market and bought a stock that they had owned in the past, but sold at a certain point in time. The results of the empirical study showed that investors bought a stock they’d owned before only if they made money on it the first time they owned it and only if the stock’s price had gone down since they bought it.

“This is all about regret: You would not want to buy back a stock that you’ve had a bad experience with, and if you sold for a gain but the stock price ended up rising when you sold, you wouldn’t want to own that stock again either, because you’re going to regret selling it,” Odean, (left), says. “But if you can sell for a gain and you can buy it for a better price, that’s when you will buy that stock again.”

It may sound simple, but regret is a huge parameter that most people are not even aware of, and managing regret plays a major part in the emotional side of financial decision-making.

Regret is also a key factor in what Odean calls the “disposition effect.” His research through the years has shown that investors are more disposed toward selling stocks that have made money, while holding onto those that are poor performers. Even though the results of this can be counterintuitive and even detrimental to a stock portfolio, the overriding reason has to do with managing their emotions vis-à-vis the stocks they own, in particular the regret at owning stocks that are poor performers.

“When people hold onto stocks that are losers, they are trying to minimize their regret, because if a person sells at a loss, he or she runs the risk of regretting that they bought that stock in the first place,” Odean says. “If people hold onto their poorly performing stocks, though, they’re doing so because they’re telling themselves that the market will come back, and they’re coping with their regret by convincing themselves that those stocks that are performing badly will turn around.”