Strack, P. & Viefers, P. (2014) “Regret and economic decision-making“, VoxEU Organisation, 16 October.
Regret can shape preferences and thus is an important part of the decision-making process. This column presents new findings on the theoretical and behavioural implications of regret. Anticipated regret can act like a surrogate for risk aversion and could deter investment. However, once people have invested, they become attached to their investment. This commitment is higher with better past performance.
The leading normative theory in economics – expected utility theory – postulates that individuals should evaluate the options they face based only on these choices’ qualities. The decision to sell a stock, for example, should be based only on the stock’s current price and expectations about the future – not on its historical prices. For many, however, selling a stock for €1,800 that just a few weeks ago was trading at €2,000 feels like a loss, and they are reluctant to realise this loss by selling the stock. People tend not to evaluate their current situation based solely on its own qualities.
Prospect theory
There is ample evidence that our willingness to take risks is influenced by prior gains and losses (Grinblatt and Keloharju 2000, Weber and Camerer 1998, Gneezy and Potters 1997, Haigh and List 2005). The leading theoretical model that explains such behaviour is Kahneman and Tversky’s prospect theory (1979). At the heart of prospect theory stand the assumptions that we:
- Evaluate outcomes relative to a reference point (prior expectations, our status quo, etc.), and that everything above is a gain, everything below is a loss;
- Dislike losses more than we appreciate gains of equal size; and
- Dislike losses so much that it makes us willing to take greater risk to avoid them.
Just what determines the reference point that is such an important driver of behaviour is a question for which Kahneman and Tversky (and related research in the 35 years since the publication of their seminal article) offer only partial answers.
In a recent study, we explore – both theoretically and experimentally – how people behave when their reference level is equal to the best offer they received in the past (Viefers and Strack 2014); that is, a model where your felicity from selling for €1,800 is lowered by the regret associated with not having sold at a higher price. While regret theory is not new to economics (Loomes and Sugden 1982, Wald 1945, Savage 1951), it has been predominantly applied to static now-or-never decisions. Note that this theory not only specifies what the reference price is, but also points that it is not a fixed level. It is a path- or context-dependent theory where reference points can change with every history of past offers. Depending on how the world plays out, regret leads to different preferences.
Relevant posts:
- Oomsels, P. (2014) Better together – a new hope for a federal Europe, EU Observer, 08 October.
- Siekmann, H. & Wieland, V. (2014) “The German Constitutional Court’s decision on OMT: Have markets misunderstood?“, Centre for Economic Policy Research, Policy Insight No. 74, October.
- Mushaben, J. M. & Abels, G. (2014) “The lack of gender equality in EU decision-making means EU citizens are still suffering from a ‘double democratic deficit’“, LSE EUROPP Blog, 28 August.