In decision theory, on making decisions under uncertainty—should information about the best course of action arrive after taking a fixed decision—the human emotional response of regret is often experienced, and can be measured as the value of difference between a made decision and the optimal decision.
The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this possibility. Regret is a negative emotion with a powerful social and reputational component, and is central to how humans learn from experience and to the human psychology of risk aversion. Conscious anticipation of regret creates a feedback loop that transcends regret from the emotional realm—often modeled as mere human behavior—into the realm of the rational choice behavior that is modeled in decision theory.
Description
Regret theory is a model in theoretical economics simultaneously developed in 1982 by Graham Loomes and Robert Sugden, David E. Bell, and Peter C. Fishburn. Regret theory models choice under uncertainty taking into account the effect of anticipated regret. Subsequently, several other authors improved upon it.
It incorporates a regret term in the utility function which depends negatively on the realized outcome and positively on the best alternative outcome given the uncertainty resolution. This regret term is usually an increasing, continuous and non-negative function subtracted to the traditional utility index. These type of preferences always violate transitivity in the traditional sense, although most satisfy a weaker version.
Evidence
Several experiments over both incentivized and hypothetical choices attest to the magnitude of this effect.
Experiments in first price auctions show that by manipulating the feedback the participants expect to receive, significant differences in the average bids are observed. In particular, "Loser's regret" can be induced by revealing the winning bid to all participants in the auction, and thus revealing to the losers whether they would have been able to make a profit and how much could it have been (a participant that has a valuation of $50, bids $30 and finds out the winning bid was $35 will also learn that he or she could have earned as much as $15 by bidding anything over $35.) This in turn allows for the possibility of regret and if bidders correctly anticipate this, they would tend to bid higher than in the case where no feedback on the winning bid is provided in order to decrease the possibility of regret.
In decisions over lotteries, experiments also provide supporting evidence of anticipated regret. As in the case of first price auctions, differences in feedback over the resolution of the uncertainty can cause the possibility of regret and if this is anticipated, it may induce different preferences. For example, when faced with a choice between $40 with certainty and a coin toss that pays $100 if the outcome is guessed correctly and $0 otherwise, not only does the certain payment alternative minimizes the risk but also the possibility of regret, since typically the coin will not be tossed (and thus the uncertainty not resolved) while if the coin toss is chosen, the outcome that pays $0 will induce regret. If the coin is tossed regardless of the chosen alternative, then the alternative payoff will always be known and then there is no choice that will eliminate the possibility of regret.
Anticipated regret versus experienced regret
Anticipated regret tends to be overestimated for both choices and actions over which people perceive themselves to be responsible. People are particularly likely to overestimate the regret they will feel when missing a desired outcome by a narrow margin. In one study, commuters predicted they would experience greater regret if they missed a train by 1 minute more than missing a train by 5 minutes, for example, but commuters who actually missed their train by 1 or 5 minutes experienced (equal and) lower amounts of regret. Commuters appeared to overestimate the regret they would feel when missing the train by a narrow margin, because they tended to underestimate the extent to which they would attribute missing the train to external causes (e.g., missing their wallet or spending less time in the shower).
Applications
Besides the traditional setting of choices over lotteries, regret aversion has been proposed as an explanation for the typically observed overbidding in first price auctions, and the disposition effect, among others.