How do regret aversion and herding connect, and why do they amplify bubbles?

Question

AcadiFi · Accepted Answer

Regret aversion is the emotional bias of avoiding decisions that could produce painful regret later. Herding is the tendency to follow the crowd. The link: herding reduces anticipated regret by socializing outcomes — 'if everyone is wrong, at least I wasn't alone.'

Mechanism:

1. An investor faces an independent decision with uncertain outcome.
2. Regret of being wrong alone feels worse than regret of being wrong with others.
3. Following consensus ('buying the FAANG names', 'piling into crypto in late 2024') feels safe.
4. Collective positioning pushes prices away from fundamentals.
5. Mean reversion hurts everyone, but because the loss is shared, individual regret is muted.

Real examples:

- 1999 dot-com bubble: PMs who underweighted tech risked career loss from client criticism; the 'fear of being wrong alone' drove herd buying.
- 2021 SPAC mania: institutions chased deals they privately distrusted to avoid client complaints about missing returns.
- 2008 AAA CDO accumulation: every bank held the same structures; 'no one got fired for owning AAA.'

Consequences and mitigants:

- Contrarian strategies generate excess returns partly because they are uncomfortable (Value, Quality in small-cap).
- Systematic rules-based investing bypasses herd anxiety.
- Diversified decision-making committees with dissent expectations reduce groupthink.
- Pre-commitment journaling — record the thesis before consensus forms — anchors decisions to fundamentals.

For L3 vignettes: spot regret aversion when the client asks 'what is everyone else doing?' and watch herding drive a concentration or sector overweight that doesn't match the IPS.

How do regret aversion and herding connect, and why do they amplify bubbles?

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