Why it feels easy to do nothing

Behavioural Finance aims to understand how and why people make certain financial decisions.  Much of economic theory assumes people will act “rationally”, yet reality frequently upsets these elegant theories.  By gaining an understanding of how we interpret financial information and react to it, we can perhaps reduce the harmful effects of some of our instinctive “humanness”.

Regret Aversion

One Behavioural Finance concept worth grasping is Regret Aversion.  We instinctively try to avoid a situation of regret or disappointment.  It’s not hard to see how we have become hard wired for this trait.  If we burn our hand on the side of the toaster, we don’t put our hand their again.  However it’s a small step from this useful application of regret aversion to “well once at school when I spoke to the class, someone laughed, so I never talk in front of groups now”.

Often, regret aversion is at the heart of procrastination.  We can see that undertaking a certain action makes sense, but there is a chance this bad thing might happen, so lets just be safe and do nothing.  This thought process is why most people don’t become self employed.

We all know that share markets have had a volatile and difficult time over recent years.  It is tempting to conclude, “investing is for mugs, I’ll just put my money under the bed, it can’t go down that way”.

In 1990 the Australian share market declined 17.52%.  This was only 3 years after the 1987 stock market crash where markets declined over 30% in a matter of days.  Then, like now, there would have been some, applying the regret aversion thought process.  “I can’t stand any more of this volatility, I’ll just put my money in the bank where it is safe”.

Over the next 10 years, the Australian Share market gained an average of 14.8% per year, whilst cash earned between 5% and 6% for most of that period.

There is an interesting experiment reported by the Journal of Economic Psychology looking at peoples preparedness to exchange one lottery ticket with another.  Even though they could could achieve a bonus for exchanging, may none-the-less chose not to exchange, fearful it seems, of the regret they would feel should the ticket they gave away prove to be the winner.

Regret aversion is an understandable, instinctive, human trait.  However if we understand this natural tendency within ourselves, we can perhaps question our decisions.  Is this decision I’m making rationale given the current facts, or am I letting some past event, which has little if any relevance to the current circumstance, lead me in a direction that is not in my bests interests?