"If only I had..."

The psychology of regret can be very useful in investing.

A recent article by Michael Mauboussin, of Legg Mason, points this out beautifully.

You see, psychologists refer to the tendency to consider what would have happened if you had taken a different action as counterfactual thinking. This way of thinking can work to your benefit, but it can also create traps.

One example of a trap is called inaction inertia. Inaction inertia occurs when you initially fail to take advantage of an investment opportunity, say buying Microsoft in 1996, and subsequently pass over the same opportunity in the future, say buying Microsoft in 1997, because its price has run up from where it was in 1996.

If an investment opportunity is good right now, you should buy regardless of the price you could have gotten if you'd acted earlier. I learned this the hard way with Leucadia in 2002, 2003 and 2004 when I didn't purchase because the price had gone up, but then finally got it right in 2005.

A benefit of the psychology of regret results from learning about errors of action versus errors of inaction. You see, some regret is good because it encourages future changes in behavior.

Most of us tend to focus on short term regrets related to action. Like, I wish I hadn't eaten that whole platter of brownies.

But, it can be equally beneficial to also focus on regrets related to inaction. Warren Buffett is famous for bemoaning the investments he didn't make more than the investment he did make. He knows his greatest investment errors were sins of omission rather than commission.

If you consider both the investments you've made as well as the investments you haven't made, you can learn from your mistakes and become a better investor.

One of the biggest psychological traps investors fall into is due to their psychological immune system. This system exists to help bad situations seem better, but they can lead to big investing mistakes.

"First, we tend to explain away situations in a way that makes us feel better." Like, someone who gets turned down for a job and tells themselves they didn't want it anyway. This kind of thinking leads to investing errors that aren't learned from. Don't explain away errors dismissively, try to understand what went wrong.

"Next, we seek facts that support our views and disavow or dismiss factors that don't back us up. This is known as the confirmation bias." If you read every article that says that Google or Apple is the greatest investment ever, but fail to read the articles critical of those companies, you probably won't make good investment decisions. Look for evidence that your investment ideas may be flawed.

"We also exhibit hindsight bias. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did." How many people insist they knew an investment would do well but failed to act. Did they really know it beforehand, or are they just convincing themselves they knew after the fact? Write down your thinking beforehand and you'll find out what you really thought instead of what you hazily remember you thought.

"Finally, when we make a prediction or take an action that doesn't work out, we believe we were almost right--the close-call counterfactual." If I had a dime for every investment I almost made and went up, I'd have a lot more money than I do. Once again, write down what you think beforehand, then you can check to see whether your close-call wasn't just a rationalization after the fact.

To avoid making mistakes with the psychology of regret, "be aware of how the mind works and the suboptimal behaviors that may ensue." If an investment is good, make it regardless of the price you could have paid if you'd invested earlier. Be sure to consider your inaction as well as your actions. There may be a lot to learn from what you didn't do.

Also, "be careful not to kid yourself." Don't just explain away situations in a way that makes you feel better. Look for disconfirming as well as confirming evidence. Write down what you think will happen beforehand so you can check whether you are suffering from hindsight bias or the close-call counterfactual.

Understanding the psychology of regret just may make you a significantly better investor. It sure has helped me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.