Investment planning is as much an art as a science. While the science part deals with various calculations pertaining to certain parameters like return or risk, the judgement required in assessing the needs or the risk appetite is the art of investment planning.
The financial planners try and assess the risk appetite by asking certain questions or going through the investor’s past experiences and the actions taken at those points of time.
Most agree that people at large are risk-averse, which means that while taking investment decisions, they evaluate various risks with respect to the potential of returns they bring along. If the risk is rewarding enough, only then they make the investment decision in favour of said option / instrument. This hypothesis suggests that the investors are rational when it comes to taking investment decisions. The whole premise of classical Economics is based on this assumption. However, various studies have proved that this hypothesis is not correct.
This is where behavioral economics steps in. Behavioral economics says people are not risk-averse, they are loss-averse. Loss-aversion only suggests that investors act in a manner to avoid losses. This can very well explain why investors exit their equity (risky) investments in light of paper losses. However, this does not explain why investors should buy more – and sometimes even with borrowed funds – during bull markets.
So, I would go one step further from loss-aversion to suggest that people are not only loss-averse; they are actually regret-averse. Let us try to understand this.
The dictionary meaning of regret is, “to feel disappointed or distressed about”. What would an investor do when presented with an investment opportunity? There are only two options: buy or do not buy. If the investor buys and the price goes down, there would be disappointment; on the other hand, if the investor does not buy and the price goes up, there would be disappointment. Both the situations are capable of causing regret.
It is this regret that the investor wishes to avoid. In order to do so, many investors tend to follow the trend, which is, buying in a rising market and selling in a falling market. Psychologists refer to the emotions driving such actions as greed and fear respectively. It is often the same investor, who swings between greed and fear. As explained above, both are the result of regret-aversion.
In the raging bull market of 1999-2000, when technology-media-telecommunication stocks were going through the roof, many so-called risk-averse investors terminated their bank deposits on a premature basis and invested the proceeds in the technology stocks or mutual funds investing in such stocks. Later when the markets came tumbling down, many of these came out of the stocks and went back to bank deposits or RBI bonds. This has been witnessed across market cycles and across markets as well.
Those who have seen the high property prices in mid-1990s and the subsequent slump should be able to associate with the above example.
Time and time again, such inflow and outflows have become quite common.
So what is the logic behind such behavior – getting in the market when the prices are high and getting out when the prices have crashed? The simple answer is “regret-aversion”.
In rising markets when we hear stories of someone making money through stock investments, the immediate thought that comes to mind is the “Super Rin” thought – “bhala uski kameez meri kameez se safed kaise?” It could as well be “bhala uski sari meri sari se safed kaise?” We compare the upsides – remember “we compare”. It is a relative situation that we are interested in.
In falling markets, we do not think whether my loss is less than someone else’s. The thought is that “oh no, we have lost some.” There is no comparison here – no relativity.
Both the cases invoke feeling of regret in us. Such thinking can only be harmful to one’s own mental and financial health. Think about it.