People avoid loss, regret rather than rely on 'risk-return' financial strategy

UNIVERSITY PARK, Pa. — People make financial choices to avoid losing money or experiencing regret, rather than simply balancing expected monetary returns with their tolerance for financial risk, according to a new study led by Lisa Posey, associate professor of risk management in the Penn State Smeal College of Business.

For many years, economists proposed that people try to maximize their satisfaction with a monetary outcome by balancing risk and returns. But this standard theory often fails to match how individuals behave, Posey said.

In a recent publication in Journal of Risk and Uncertainty, Posey and her colleagues tested two alternative models, one incorporating people’s heightened concern about losing money and a competing one focusing on their desire to avoid regretting their decisions. They were trying to see if, rather than being competing explanations, these models might work together to explain behavior. The team found that people bias their choices to avoid the possibility of losing any money and also behave differently when they can observe what they could have earned if they had chosen differently. The results also indicated that women, on average, are more likely than men to make decisions to avoid the potential of regretting choices that result in less money.

“Any company that sells insurance or financial products — or any government agency that tries to influence financial behavior like retirement saving — needs to understand how people make financial decisions in order to market products effectively or to encourage their desired behaviors through regulation,” Posey said. “In this study, we showed that the potentials for loss and regret often affect people's decisions.”

Avoiding loss

To test people’s tendency to avoid losses, the researchers recruited 228 individuals and provided them with $17 each to participate in a gamble-based experiment. Over multiple rounds, participants selected one of two gambles with different outcomes. In one gamble, for example, participants might be able to win $7 or lose $7, while in the other gamble, they could either win $0 or lose $7. In this scenario, almost all participants would select the first gamble, because there is no advantage to the second gamble.

Throughout the experiment, participants had a 75% chance of receiving the higher amount and a 25% chance of receiving the lower amount for whichever gamble they selected. Additionally, they did not receive feedback about whether they received the higher or lower amount from each gamble at any point.

In each subsequent round of the experiment, the first gamble remained the same, but the second gamble improved incrementally. For example, participants might be able to win $1 or lose $6 and then in the next round win $2 or lose $5, and so on. The participants selected their preferred option, and the process repeated several more times with the second gamble option improving each time. As the second gamble option became a better deal, participants switched at some point to selecting that one over the first gamble.

The researchers discovered that people were very likely to select the second gamble option as soon as it had no possibility of losing money, even though it was an incremental improvement and was not the most profitable time to switch their bets.

“People were not focused only on winning the most money,” Posey said. “Instead, they prioritized not losing money. People like making money — but they often care more about not losing money, even when risking loss appears to be the better strategy.”

Across the experiment, if people could lose money on the second gamble option, they were 10 percentage points more likely to avoid that gamble than when the option had no possibility of loss. Over the course of the experiment, women were 15 percentage points more likely to avoid potential losses while men were eight percentage points more likely to avoid potential losses.

Avoiding regret

To test people’s tendency to avoid regret, the researchers conducted two variations of the gamble-based experiment with the same participants. In these sessions, participants were either informed only about the outcome of the gamble they selected, or they were informed of the outcome of both gambles.

When participants could see the results of both gambles, either choice could lead to regret because people could always see when they selected the less profitable option.

When participants could see only the outcome of the gamble they selected, they only risked regret if they selected the first gamble option, because those who selected the second option could not know if the first would have given a better outcome. Those who selected the first option and received the lower outcome would experience regret because selecting the second gamble option would have been superior. In the example above, if the first gamble had outcomes of losing $7 or winning $7, and the second gamble had outcomes of losing $2 or winning $5, losing $7 would mean you selected the poorer option, so you could experience regret even without knowing whether you would have lost $2 or won $7 by selecting the other gamble option.

The researchers considered participants to be regret-avoidant if they were more likely to select the second gamble option when the outcome was revealed only for the selected gamble, while all other conditions remained the same.

Results showed that women were six percentage points more likely to avoid a gamble they might regret. Men’s behavior, on the other hand, did not appear to be affected by regret.

“If the average woman in this study needed to pick between purchasing two stocks, and she selected a stock that made money, she would feel good about that,” Posey explained. “If, however, she saw that the other stock made even more money, she would regret not choosing that stock. Importantly, she would take those potential feelings into account when making her decision. What’s more, almost all participants were working to avoid loss at the same time. When you combine the loss aversion and regret aversion, it can lead to very different financial decisions than standard models might predict.”

Implications for business, government and beyond

“Any business or policymaker that relies on people’s financial decisions needs to understand and incorporate loss avoidance and regret avoidance in their models,” Posey said. “Otherwise, the businesses may not optimize their products or profits, and the policies may not achieve their goals.”

Additionally, she noted that the human tendencies driving these results may extend well beyond financial choices.

"These same forces may matter in many real-world choices,” Posey said. “From buying stocks to finding a partner on a dating app, people may weigh the downside more heavily than the upside while also trying to avoid the regret that comes from learning a choice they passed up would have turned out better for them."

Other contributors to this study included Anthony Kwasnica of the Department of Economics at Florida State University and Charles Geier of the Department of Human Development and Family Science at the University of Georgia.

Experiments for this study were conducted in the Laboratory for Economics, Management, and Auctions in the Smeal College of Business.