Regret a R T

practice management / technology

Emotions Series: c l e I Regret a r t

D By Meir Statman, Ph.D. 20-year Treasury bond purchased for $1,000 a year ago might have de- r e Editor’s note: This is the fourth in a series of clined to $900 because interest rates U articles about emotions and the lessons they increased during the year. Normal hold for investment advisors and their clients. investors frame a bond into a mental e a t account, distinct from mental F accounts that contain their other as- our client’s target sets. This bond mental account now asset allocation is 60 Meir Statman, Ph.D. registers a $100 paper loss relative to percent equities and the purchase price. Normal investors Y40 percent bonds, but now that the very well because the doctors at that are fooled by hindsight into believ- stock market has zoomed, the actual hospital were not very competent. ing that they could have seen in allocation to equities has increased You surely feel the physical pain in foresight that the value of the bond to 70 percent and the actual alloca- your leg, but do you feel the extra was about to decline. They feel the tion to bonds has decreased to 30 emotional pain of regret? pain of regret when they observe the percent. Would you rebalance the You had a choice whether to $100 paper loss and that pain only portfolio to its target allocations or make the trip that day or not and intensifies when they realize the loss leave it alone? you carry responsibility for that because realization extinguishes all Choices about portfolio rebalanc- choice. Mental accounting bias leads hope of recovery. ing are a crucial part of the practice you to frame this particular trip in Rational investors always prefer of financial advisors. These choices a mental account distinct from the more wealth to less and never are never are easy because they have mental accounts of all other trips confused by the form of wealth. both monetary consequences and you have made without incident. Normal investors do not conform emotional ones. Your client’s wallet Hindsight bias leads you to believe to that definition. Normal inves- would be fatter if stocks tumble soon that you could have seen in foresight tors distinguish paper losses from after you rebalance by selling some that the road would be congested realized losses that are different only of them. But it would be thinner if that day, chosen not to drive, and in form, and they are willing to sac- stocks continue to zoom. Moreover, avoided the accident. Now you re- rifice wealth as they forego the tax you’ll feel the emotion of pride if gret the choice to drive that day. But benefits of realized losses. Yet many your client’s wallet is fatter, but you had no choice of the hospital studies, including those of Shefrin you’ll feel the emotion of regret if you were taken to after the accident and myself (1985) and Odean (1998) your client’s wallet is thinner. because you were unconscious at the demonstrate that the reluctance to Kahneman and Tversky (1982) time. So you bear no responsibility realize losses is common. described regret as the pain we feel for the choice of hospital and suffer We can also see the effect of when we easily can imagine a differ- no additional regret that would have aversion to regret in the quest for ent choice that would have led to a come if you’d had a choice of hospi- “mental liquidity,” a term coined better outcome. There is a close link tals and chosen the one employing by Fisher and myself (2007). As- between the emotion of regret and incompetent doctors. sets are economically liquid when the cognitive biases of mental ac- We can see the effects of aversion they can be sold quickly with no counting and hindsight. And there to regret in many financial contexts, loss relative to their fair market is a close link between regret and the including the “disposition effect.” value. Assets are “mentally liquid” responsibility for choice. Shefrin and I (1985) coined this term when they offer investors options To understand the links, imag- to describe the reluctance of inves- to obscure losses relative to refer- ine that you fractured a leg in a car tors to realize losses and attributed it ence prices and options to avoid accident, lost consciousness, and to cognitive biases, namely mental their realization. The price of the were taken by an ambulance to a accounting and hindsight, and the Treasury bond purchased for $1,000 hospital. Your leg healed, but not emotion of regret. The price of a a year ago declined to $900. That

24 The Monitor The Voice of the Investment Management Consultants Association www.imca.org © 2007 Investment Management Consultants Assocation, Inc. Reprint with permission only. bond is almost perfectly economi- I arranged to rebalance my portfolio client: “If we’re being honest, it was cally liquid; investors can sell it for by switching in equal increments on your decision to follow my recom- $900 less a small commission. But the 12th of each month during the mendation that cost you money.” the mental liquidity of the bond is following eight months. Decisions to rebalance portfo- impaired if investors are unable to The rational professor of finance lios are wise but they are difficult avoid the observation of paper losses in me frowned on this arrange- because rebalancing has a greater relative to the purchase price or if ment, but the normal investor in me potential for imposing regret than they feel compelled to postpone the chuckled. I, like all normal people, leaving things alone. Aversion sale of the bond so as to avoid the want to avoid the pain of regret. to regret instills in advisors the regret that comes with the realiza- Switching gradually in a sequence unwise inclination to refrain from tion of losses. Still, the bond is more we know as dollar cost averaging is rebalancing portfolios, but advisors mentally liquid than a stock because designed to avoid the pain of regret. can overcome that inclination by bondholders have the option to wait I had a choice to switch in one making rebalancing a routine part of until the maturity date and avoid lump sum or switch in small incre- their practices. Routine serves as an the realization of losses while stock- ments during the following eight effective defense against regret be- holders do not have that option. months. I was responsible for the cause routine reduces responsibility. We observe the importance of choice and I easily could imagine that In turn, reductions in responsibility aversion to regret in commentary the stocks I was switching into in one yield reductions in the potential for about the advantage of ladders of lump sum would take a tumble the regret and the need of clients and individual bonds over bond mutual day after I switched. I could antici- advisors to play the blame game. funds. Individual bonds have greater pate the pain of regret I would feel mental liquidity than bond mutual and wanted to avoid it. Dollar cost REFERENCES funds because bondholders have the averaging helped me do that. When Fisher, Kenneth, and Meir Statman. 2007. option to wait until the maturity of I switch only a portion of my stocks “Mental Liquidity.” Journal of Behav- each bond, receive the bond’s face I feel regret if they decline soon after, ioral Finance 8, no. 2: 79–83. value, and avoid the pain of regret but not as much as I would feel if I Kahneman, Daniel, and Amos Tversky. that comes with the realization of were to switch the entire amount. 1982. “The Psychology of Preferenc- losses. Bond mutual fund holders Financial advisors know well es.” Scientific American 246: 167–173. have no such option because bond the pitfalls of regret in the attempts Odean, Terrance. 1998. “Are investors mutual funds have no maturity date of clients to avoid it by shifting reluctant to realize their losses?” and the marking-to-market of net as- responsibility. There is some laughter Journal of Finance 53, no. 5 (October): set value implies that investors never and much bitterness in the old 1,775–1,798. are assured that they can avoid the saying among stockbrokers: “When Shefrin, Hersh, and Meir Statman. 1985. realization of losses, no matter how the stock goes up the customer says “The Disposition to Sell Winners long they wait. I bought the stock. When it goes Too Early and Ride Losers Too Long: I experienced my own aversion to down the customer says my broker Theory and Evidence.” Journal of regret last year when I reviewed my sold me the stock.” Brokers and fi- Finance 40 (July): 777–790. portfolio and decided to rebalance it nancial advisors are tempted to strike Statman, Meir. 1995. “A behavioral by increasing the allocation to a par- back, shifting responsibility and the framework for dollar cost averaging.” ticular group of stocks. But I did not pain of regret to clients. A cartoon Journal of Portfolio Management (fall): rebalance it all in one day. Instead, shows a financial advisor saying to a 70–78.