In an insightful book, “50 Psychological Experiments for Investors”, the author, Mickael Mangot, writes on regret aversion.
“Loss aversion is only a special case of a broader behavioral bias: regret aversion. The prospect theory, developed by Kahneman and Tversky (1979), which merited the Nobel Prize in Economics in 2002, points to a greater sensitivity to the value-function below the reference point of the individual. Geometrically speaking, the curvature of the value-function shows a larger slope for losses than for gains. A loss compared to the reference point is thereby perceived on average 2.25 times more negatively than a gain of the same amount is perceived positively. In this theory the reference point is not specified. If this reference point is the price, then the individual clearly demonstrates a loss aversion. But the general case is that below the reference point the individual shows regret. Relative to the purchase price, it is the regret at having chosen a losing investment; relative to the market return, it is at having chosen an underperforming investment; relative to the highest price during a certain period, it is at not having sold at the right time, and so on. Several studies prove indirectly that it is not automatically the purchase price which is used as the reference point by the investor. It is this changing point that determines whether it is an occasion for regretting or rejoicing and therefore keeping the asset rather than selling it.
Grinblatt and Keloharju (2000) show in a statistical study on the behavior of investors in the Finnish market that individual investors have difficulty selling securities which are losing relative to the market and that the difficulty is even greater when the underperformance is more recent. After a month, the impact on these investors of low return compared to the market is no longer significant. The results suggest that it is not so much the total performance which is scrutinized as the market scenario. An investor is often reluctant to give up a winning stock (relative to the market) if it has recently underperformed. Thus, to compensate for the reluctance to sell caused by a loss on day one, it would be necessary to have achieved gains five times higher in the previous month. Conversely, the more recently a security has outperformed the market, the more it has a chance of being sold. The parameters found by the authors suggest that a recent outperformance can easily compensate in the mind of the investor for an even more serious loss. For example, for individual investors, an outperformance on day one urges them to sell as much as an underperformance ten times as large recorded in the previous month dissuades them from doing so.
The investor's level of satisfaction depends not so much on his performance, even if very recent, as on the image it sends to him of himself. A very illuminating study of this distinction is provided by Nofsinger (2001). Specifically, the author analyzed the trades made between November 1990 and January 1991 by individual investors in 144 companies listed on the New York Stock Exchange. Nofsinger paid special attention to investors' reaction to information on the company and to macroeconomic information. In accordance with the disposition effect, good news about a company increases its price on the Exchange and causes investors to sell its shares. Similarly, news about a company which makes its price go down encourages retention of the stock. Nofsinger finds, on the other hand, that general hikes in price following good macroeconomic indicators do not (or only slightly) encourage selling. This result implies that investors sell earning stocks especially if they can take personal pride in themselves for the realized performance. Conversely, a loss is less badly received when it is the whole market which is going down because then it does not elicit regret at not having invested as well as others. The investor can more easily sell when the loss does not impugn him personally.
It is more the performance relative to the market than the absolute performance which is decisive for ordering a sale. That means, if loss aversion is almost generally present among investors, that the reference point used also varies widely from investor to investor. The multiplicity of reference points (purchase price, gains, market return, and others) argues for a large natural heterogeneity among individuals or for a significant instability in the cognitive processes of decision making. It also encourages one to wonder whether this instability would be permanent or ad hoc. Does the investor voluntarily change his reference point in such a way to maximize the satisfaction he derives from his investments? In other words, is the investor of good or bad faith? Little debated in the literature, this question is far from being resolved.”