Je ne regrette rien? An Empirical Test of Regret Theory and Stock Returns

Abstract

We examine the asset pricing implications of regret theory. In our model, investors mentally represent a stock by the distribution of its past returns and evaluate it following regret theory. Investors feel the sensation of regret if their investment performs worse than an unchosen alternative and anticipate this feeling in their evaluation. Consequently, stocks with a high (low) potential for regret get undervalued (overvalued) and, on average, earn high (low) subsequent returns. We find empirical support for this prediction in the cross-section of U.S. stocks. Our results cannot be explained by common risk factors, return reversals, and other behavioral theories.

Keywords: regret theory, counterfactual thinking, asset pricing, return predictability

JEL Classification: G11, G12, G41