May 10, 2022
Overcoming regret in the investment process
By Kavedon Kapital Team
Our emotional well-being frequently trumps other motivations. Within the complex behavioural biases, Kavedon Kapital considers regret as one of the most challenging to overcome. Yet, the academic and practitioner literature has paid relatively little attention to it. Neurologically, the impact of regret targets the same part of your brain as a punch to the face; regret won’t necessarily result in a black eye, but the psychological scars will feel similar. Given a set of options, we tend to select the option that yields the least amount of regret.
2021: Regret in Action
Last year, courtesy of very accommodative fiscal and monetary policy, risk assets blossomed, generating positive returns. Specifically, 2021 was a record year for VC funding leading to surging valuations and over 500 venture-backed companies becoming unicorns. However, our conversations with investors revealed a general sentiment of caution throughout the year. Whilst the macroeconomic landscape had been a great driver of returns, rising markets across all assets can’t last forever — the fear of being an exogenous shock might cause a reversal in performance. 2022 has thus far realised those fears. However, when the investors were asked whether they would be de-risking their portfolio? Most investors answered “no”!
So why the disconnect between concerns and actions? Our hypothesis is this behaviour is driven by regret aversion. If investors align actions with their expectations (i.e. de-risk), one possible scenario is that risk assets continue to accelerate. This is essentially the regret outcome: the individual would exhibit inferior performance versus competitors and peers. Another result is that they de-risks, and the market moves in line with expectations — which is a very positive experience, as performance would be superior to the broader market. However, while this scenario is positive, it does not produce enough satisfaction to offset the potential regret, so intuitively investors will go with option 3: do nothing. The regret of taking action and triggering a negative outcome is felt far more acutely than doing nothing, a suffering of the masses.
Process over outcome
It’s straightforward for those involved in investment decision making to evaluate decisions relative to the profit and loss of each investment. Therefore, we tend to account for all profit-making investments as good ideas and loss-making trades as bad ideas. At Kavedon Kapital, we don’t believe it should be as simple as that. The key to overcoming regret is this: focus on the process, not the outcome. We will make decisions that will yield negative outcomes throughout our lives — that does not necessarily make them bad choices. Decisions should be evaluated based on the time a decision is made and not on the outcome.
Take, for example, a game of head and tails. There are two games to play: one with a payoff of €10 and the other of €1. You can only play one game, and entry is free. Rationally, individuals should play the €10 game. If you fail to win the €10 game, you are shown the outcome of the €1 game, which reveals that had you played, you would have won €1. You may regret that you didn’t play in the €1 game, but selecting this option would be utterly irrational as all the available information led you to choose the €10 game. If a decision at the execution point reflects all the available information, you should not beat yourself up ex-post if that outcome is undesirable.
Therefore it is imperative to stick to your investment and idea generation processes — and reflect this thinking in actual portfolio construction. Under this framework, it is possible to overcome the strong tendency we have to select suboptimal decisions to avoid regret.
Our minds are tainted
Given the strong emotional desire to avoid regret, our future investment decisions are also likely to be tainted with previous negative experiences. This is particularly challenging within the nexus of venture capital. Let’s consider an area of significant activity right now, green hydrogen, and it’s potential to decarbonise swathes of the global economy. One of the challenges for this energy vector is the cost of production and efficiency. As such, advances in upstream technology i.e. the ability to produce green hydrogen in line with fossil fuel prices, will be a significant determinant as to whether it will be a solution or whether the hype around the world’s most abundant element is hot air. However, hydrogen as a solution is not new, the potential has been with us for decades, but it has never taken off. If we invested ten years ago and it yielded negative outcomes, our propensity to objectively evaluate future green hydrogen opportunities is challenged. Our minds are tainted before we even open the pitch book and meet the founders.
So, the takeaway here is, that regret can systematically damage your opportunity set. If this behaviour reflects the majority of historical investments that have yielded negative outcomes, it will generate a long list of opportunities you are reluctant to invest in. Again, have faith in the process and don’t let your decision making be guided by regret. You can control your process but you can’t control outcomes.
If you are an Investor realising the importance of switching to a Venture Capital model built on Circular Economic principles, get in touch with us to learn more about how Kavedon Kapital can help.
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