Experiment 2: Project evaluation and regret aversion

This second experiment is aimed at studying the effect of regret aversion on individuals' decisions whether to continue or abandon a given investment (project evaluation). As outlined previously, it is optimal to abandon an investment when the expected value with continuation is less than that obtainable with termination.

Allowing for managerial regret aversion, my model predicts that project evaluation

Chapter 4: Data collection methods

decisions may deviate from this normatively optimal behaviour. In the model, it was assumed that the continuation value would only be observable (ex-post) with actual continuation of the investment; on the other hand, the value obtainable with immediate termination of the investment was assumed to be always observable ex-post (type 2 partial outcome observability). Under these assumptions, the model predicts that aversion to regret is conducive to premature abandonment in the sense that investments that ought to be continued may be (sub-optimally) terminated. However, whilst the model assumed a risk-neutral decision maker, people in reality are assumed to be generally risk-averse.

This likely difference between theory and practice regarding risk-preferences poses a potential problem for empirical testing: Project termination would not only be consistent with the model prediction for regret aversion, but also with simple risk aversion. As a result, it would be very difficult to decide if observed project abandonment decisions are evidence to support the hypothesis of an effect of regret aversion. A way of overcoming this problem is to modify the feedback condition following Zeelenberg et al. (1997:15) so that the risk-averse choice is different from the regret-averse choice.

In my model, this step can be accommodated simply by assuming the mentioned type 1 partial outcome observability, under which the continuation value is always observable ex-post but the abandonment value is only observable for actual termination of the investment. Such a manipulation leads to an inversion of the model prediction, such that regret aversion should now favour project continuation. In contrast, regret aversion would still lead to project abandonment. The experimental framework presented in the remainder of this section aims to test this prediction and follows largely the experiment reported by Zeelenberg et al. (1996).

The experiment follows a post-test-only control group design, which is a true experimental design (Malhotra et al., 2003:271). Subjects are randomly attributed to one of two groups, and one group receives a treatment. The treatment effect is then studied by comparing the post-treatment observations for both groups. The general task for both groups is identical. Subjects are told to picture themselves as corporate finance managers in a medium-sized company. In addition, they read the following scenario description:

"There is one investment project which has serious problems; in fact, things are so bad that the CEO has asked you to think about whether the project should not be

Capital investment decisions with managerial overconfidence and regret aversion

abandoned immediately – after all, it was you who initially assessed the proposal and recommended to start investing in this particular project."

The subsequent choice options (continue or abandon) are outlined and also summarized in a simple pay-off table (Figure 4.4). The expected values for the project are chosen such that any unbiased risk-neutral or risk-averse individual⁶⁰ should prefer abandonment of the project.

Figure 4.4: Project evaluation set-up

Decision Probability Outcome 0.2 0 continue

0.8 -235,000 0.5 -170,000 abandon

0.5 -200,000

Following these explanations, the experimental handouts contain additional information regarding the observability of the outcomes. This information represents the treatment, and is thus different for each group. The treatment in this experiment is adopted from Zeelenberg et al. (1996) although in the present experiment there are only two instead of three different feedback conditions. Subjects in the control group are instructed that only the outcome of the option they choose will be observable to them and the fictional CEO of the company. Hence, if they continue the investment, they will not find out what outcome they could have achieved had they decided to terminate the project instead, and vice versa. Since there is no counterfactual feedback in this condition, there should be no regret associated with either choice option.

In contrast, the instructions for subjects in the treatment group tell them that if they chose to abandon the project, the outcome of the foregone action (continuation) would be observable ex-post, whereas if they chose to continue the project, no feedback on the outcome for abandonment would be received⁶¹. The treatment condition thus consists of asymmetric feedback as in Zeelenberg et al. (1996) such that the regret-minimizing option (avoiding feedback) is the uncertain choice (continuation), whilst

60 Individual risk preferences of subjects are measured prior to the actual investment decision by means of a choice between two gambles.

61 In other words, the abandonment option is assumed to be unobservable (ex-post) under continuation.

Chapter 4: Data collection methods

the low-risk option (abandonment) is associated with potential ex-post decision regret.

Subjects in the control group should thus behave consistent with their risk preferences, and given that people are typically risk-averse, one would expect a significant proportion favouring the risk-minimizing option of abandonment. If anticipated regret had no impact on behaviour, then roughly the same behaviour should be observable in the treatment group, as the treatment of inducing regret aversion should be ineffective (null-hypothesis). However, assuming the existence and behavioural influence of regret aversion, subjects in the treatment group should behave in a regret-minimizing yet in the present set-up a risk-seeking fashion, which should be inconsistent with their risk preferences (unless they are natural risk-seekers anyway). At the end of the experiment, subjects are also asked to indicate the reasons underlying their decision.

4.5 Summary

In this chapter, the chosen data collection methods were presented and justified. The purpose of the methods is to gather empirical data by which the predictions of the theoretical model can be evaluated. Following some general epistemological considerations, as well as a review of the research methods used in the related literature, a two methods research strategy is retained. The importance of the validity and reliability of findings in a research design that is oriented towards positivism is reflected by the preference for surveys and experiments in past finance research. By combining these two methods for my empirical research, I hope to mitigate the identified weaknesses of either approach whilst building on the combined strengths.

The construction of the survey questionnaire and the purpose of individual questions, as well as the approach for administering the questionnaire were outlined. In addition, the purpose and sequence of events of the two experiments that were designed for this research project were presented. The next chapter reports on the data that was collected with these methods and presents the results of the statistical analysis.

Capital investment decisions with managerial overconfidence and regret aversion