Calculating Regret

The processes behind decisions, particularly financial decisions, are extremely complex. Rarely decisions are solely based on reason. Fear, anxiety and regret are come of the emotions that come into play when we have to make important decisions. Choices are made based on both economic and emotional evaluations: this explains why decisions are rarely optimal, or rather, different from what sound economic models would predict.

Look at the current financial crisis: if investors had acted as rational agents the crisis would have probably never happened. Growing evidence suggests that decisions are also influenced by emotions. A recurrent phenomenon is this: investors are reluctant to take losses and want to make gains. There's nothing wrong with this, save for the fact that this makes people hold on to a stock longer than necessary when its value drops (in the hope it might climb again) and, conversely, to sell it at the beginning of a steep rise, i.e. too early. Various studies have sought to uncover decision models able to capture this phenomenon. The theory of regret is one of these. Developed in the 1980s, this theory argues that the choice among alternatives springs from the minimization of regretting over choices wrongly made. Leaving philosophical considerations over the nature of rationality aside and whether emotions are part of it, there is a basic fact: most of the empirical evidence shows that emotions play a major role in decision-making. A practical question then emerges: if emotions play a key role, who can we quantify them? Although a hard and counterintuitive task, we have to try to calculate emotions. In a recent article, "A Quantitative Measurement of Regret Theory", which I co-authored on Management Science with Han Bleichrodt if the Erasmus School of Economics and Enrico Diecidue of INSEAD, we have managed to measure the effects of regret. The research study propounds a methodology, by gathering and analyzing data coming from experiments conducted on economics students. The theory of regret is able to provide a rationale for attitudes that violate the transitivity property in preference theory (if I prefer A to B, and B to C, then I must prefer A to C). Investors that violate transitivity are more exposed to the phenomenon of so-called money pumps, i.e. dynamics that subtract money from the decision-maker without improving his situation, but rather leaving him in the initial situation. Consequently, a methodology able to measure regret, is also able to inform investors about the risks of making choices biased by it.