Investing With Regret

Regret wrecks people’s finances like no other emotion. Nothing feels worse than missing out on a rally, except buying what turns out to be a top.

Retail investors were burned badly in 2000 and 2008. “Buy and hold” blew up in their faces. While stock prices lifted in step with the Fed’s balance sheet post-crash, the traumatized little guys sat out the stock market rise until the last year.

But now small investors are piling in again, and they’re investing like it’s 1999. “I could see it going up maybe 50% at a minimum, just being conservative,” a 35-year old computer programmer told the Wall Street Journal, talking about the stock price of a small biotech company he was pouring his 401(k) money into.

More money flowed into mutual funds and exchange-traded funds last year than ever before. Even more than in 2000, the tech bubble year. 2013 was the first year investors took money out of fixed-income funds after three straight years of dumping it into them.

The stock market is one giant roller coaster of regret for retail investors. Regret for not getting in… regret for getting in too late… regret for being left holding the bag.

Behavioral economics pioneer and Nobel Prize winner Daniel Kahneman quotes two Dutch psychologists about regret in his bestseller Thinking, Fast and Slow. They noted regret is “accompanied by feelings that one should have known better, by a sinking feeling, by thoughts about the mistake one has made and the opportunities lost, by a tendency to kick oneself and to correct one’s mistake, and by wanting to undo the event and to get a second chance.”

Studies of investor brains during experiments simulating stock market investing show the variable that most drove behavior in the investment game, in all markets, was the “r-word.”

Regret was a big factor when subjects changed their investments and also “showed up as an extremely strong neural signal in a reward-decision-making region of the brain, the ventral putamen, the same site where reward-prediction error signals appear,” writes neuroscientist Dr. Read Montague. Thus, the brain treats counterfactual experience the same as it does real experience.

Regret, in this case, is the difference between the value of what is and the value of what could have been. Dr. Montague offers what he calls a pseudo-equation: “Terry Malloy’s Regret equals (value of being a contender minusvalue of being a bum). Why this is important is something called dopamine, a chemical in the brain that helps humans decide how to take actions that will result in rewards at the right time.”

As investors pile into high-flying stocks, they receive a dopamine kick to their brains similar to the sensation a drug addict receives when getting high, or the response our brains receive during sex.

The sensation occurs in anticipation of the great returns. Getting what we expect doesn’t provide a dopamine rush, only unexpected gains do. The same way an addict needs larger doses, market investors crave more risk.