Abstract
This paper examines the effect of regret aversion on trading strategy in a dealer market where investors face a trade-off between expected utility of return and expected disutility of regret. Regret aversion is found to have a profound impact on investors' trading strategies; as a result, although asset price adjusts to new information swiftly, informed traders herd to buy when the price is extremely high, while they herd to sell when the price is extremely low. This model illustrates that regret aversion can help to explain herding behavior during bubbles and crashes. It overcomes the so-called “price critique” to herding theory in a standard sequential trading model.
