Regret Theory in Finance: Impact on Decisions and Risk Tolerance

People make financial decisions based on both logic and emotion. Regret theory explains how the fear of making a wrong choice influences investment behavior, often leading to overly cautious or irrational decisions. This psychological factor shapes how investors buy, sell, and manage their portfolios.

Understanding regret’s impact helps explain trading strategies, portfolio adjustments, and overall risk tolerance.

Effects on Trading Judgments

Investors often hesitate to sell losing stocks, fearing the regret of realizing a loss. This reluctance, known as the disposition effect, leads many to hold onto declining assets longer than rational analysis suggests. Instead of reallocating funds to better opportunities, they wait in hopes of a rebound, even when market conditions indicate otherwise. During the 2000 dot-com crash, many retail investors clung to failing tech stocks, convinced they would recover, only to see their portfolios shrink further.

Fear of regret also causes premature selling of winning stocks. Investors may lock in small gains too early, missing out on further appreciation. This tendency is particularly evident in momentum-driven markets, where stocks that have performed well often continue rising. A study by Barber and Odean (2000) found that individual investors frequently sell winning stocks too soon while holding onto losers too long, reducing overall portfolio returns.

Regret influences reactions to market downturns as well. During sharp declines, some panic and sell at the worst possible time, fearing further losses. In March 2020, when the S&P 500 dropped nearly 34% in weeks, many investors who sold at the bottom missed the rapid recovery that followed. A Vanguard study found that those who stayed invested saw their portfolios recover within months, while those who sold often re-entered at higher prices, locking in losses.

Portfolio Rebalancing Factors

Investment portfolios shift over time as asset values fluctuate. Without periodic adjustments, an initially well-diversified portfolio can become misaligned with an investor’s goals. Regret theory influences whether and how investors rebalance, as emotions often interfere with rational decision-making.

One major factor is reluctance to deviate from past successes. If a particular asset class has performed exceptionally well, investors may hesitate to reduce their exposure, even if it has grown disproportionately large. This can lead to an overweighted portfolio that carries higher risk than intended. During the late 1990s tech boom, many investors let technology stocks dominate their holdings, fearing that selling would mean missing further gains. When the bubble burst, heavily concentrated portfolios suffered severe losses.

Conversely, regret aversion can prevent reinvesting in underperforming assets. If a sector or asset class has struggled, investors may avoid reallocating funds to it, even when valuation metrics suggest a strong recovery potential. In early 2009, many were reluctant to rebalance into equities after the financial crisis, despite historically low price-to-earnings ratios indicating attractive buying opportunities. Those who overcame this hesitation benefited from the subsequent decade-long bull market.

Tax considerations further complicate rebalancing decisions. Selling appreciated assets to restore balance can trigger capital gains taxes, making investors reluctant to act. In the U.S., long-term capital gains tax rates range from 0% to 20% in 2024, depending on income level, while short-term gains are taxed at ordinary income rates, which can be as high as 37%. This tax burden often discourages investors from rebalancing, even when it would improve long-term risk-adjusted returns. Strategies like tax-loss harvesting, where investors sell losing positions to offset taxable gains, can help mitigate this issue but require careful planning.

Variations in Risk Tolerance

Personal circumstances, financial knowledge, and past experiences shape how comfortable someone is with uncertainty in investing. A younger investor with decades until retirement may be more willing to take on volatility, knowing they have time to recover from downturns. In contrast, someone approaching retirement often prioritizes stability, shifting toward assets like bonds or dividend-paying stocks that provide steady income.

Beyond age, individual experiences with market fluctuations significantly impact risk perception. Someone who endured heavy losses during the 2008 financial crisis may remain cautious even in favorable conditions, while an investor who entered the market during a prolonged bull run might underestimate potential risks. This was evident in the rise of retail investors during the post-2020 rally, many of whom had never experienced a sustained market decline. Their willingness to take on speculative positions, such as options trading or cryptocurrency investments, stemmed in part from an environment where downturns were brief and recoveries swift.

Economic conditions also influence risk appetite. During periods of high inflation or rising interest rates, investors often become more conservative, favoring assets that preserve purchasing power. When U.S. inflation peaked at 9.1% in June 2022, demand for Treasury Inflation-Protected Securities (TIPS) and commodities surged as people sought hedges against eroding real returns. Similarly, when interest rates climb, fixed-income investments like bonds become more attractive, leading many to shift away from equities.