The Effect of Regret

Abstract:     
The aversion to future regret has been proposed as an explanation for many puzzles in both economics and finance. Yet very few studies (particularly outside of an experimental setting) have directly analyzed the effect of realized regret on subsequent decision making. We empirically investigate the effect of regret on future decisions in the context of stock-trading strategies by individual investors. Using data for all orders submitted by individual investors on the Shanghai Stock Exchange for one year, we find that people are more likely to change their order strategy, i.e., whether to place a desperate or patient order, after experiencing regret over their most recently submitted order. Consistent with the predictions of regret theory, we find that the effect of regret on the next order placed is stronger if the prior order was executed rather than unexecuted (i.e., action leads to more regret than inaction), if the investor lost money on the prior trade (i.e., a worse mood amplifies the effect of regret), and if the prior order represented an unusual trading strategy for the individual. Moreover, the emotionally-charged decisions made because of regret lead to worse outcomes for investors, with poor returns resulting from regret-based stock orders.

Number of Pages in PDF File: 48

Keywords: Regret Theory, Order Strategy

JEL Classification: D03, D14, G02

working papers series