Speaking last week at an investment conference, behavioral finance expert Dr. Richard Thaler of the University of Chicago warned listeners how hindsight bias can play havoc with your investment strategy. In simplest terms, hindsight bias is “the tendency to remember that our forecasts were better than they really were” or the “I knew it all along” effect.
Looking back, we think we knew or suspected something was going to happen before it happened. For example, how many times have you heard people say “they saw the tech bubble coming in 1999” or they “saw the signs that the market was going to crash in 2008?”
The problem is that empirical research shows our recollections are just not correct. Looking back after an event, test subjects claim “they knew it all along.” But prior to the event, results show they had no idea what was really going to happen.
Hindsight bias has a very powerful – and usually negative – effect on our investment behavior. How can we keep it from sabotaging our investment strategy?
Process, Not Prognostication
Investors need to start by acknowledging that their forecasting ability is far from perfect, and rely instead on a disciplined, systematic investment strategy rather than “hunches” or “instincts” to grow their wealth. That’s why sticking to a consistent asset allocation, rather than trying to time the market, is a proven and successful investment technique.
Investment adviser Larry Swedroe puts it well. “The bottom line is that hindsight bias is very dangerous. It causes investors to recall their successes, but not their failures. It also causes investors to believe that investment outcomes are far more predictable than they actually are.” To combat the effects of hindsight basis, make sure you have a rational basis for buying or selling an investment (you might even find it helpful to write down your reasons on paper). Back up your decisions with facts instead of relying on “perceptions.” Compare performance results with relevant benchmarks to improve your objectivity.
Curb Your Overconfidence
“The most obvious result of hindsight bias is overconfidence among investors. It leads them to believe that just because they predicted past events, they can do the same for the future and invest accordingly. However, these predictions invariably turn out to be wrong ” writes financial journalist Vivek Kaul of India’s Economic Times.
Los Angeles financial planner David Zuckerman agrees. “One of the most important implications of hindsight bias is that it gives investors a false sense of security when making investment decisions. Overestimating the accuracy of past forecasts can lead to excessive risk taking.”
This was confirmed in a 2008 study of investment bankers in London and Frankfurt that found traders with higher levels of hindsight bias did worse in managing investments and those with lower levels of hindsight bias had better investment results. Why? Researchers suggest that hindsight-biased traders didn’t recognize that their view of the market was wrong, underestimated risk, and failed to learn from mistakes. Those with a more realistic appreciation of their abilities and limitations correctly measured and managed risk.
Respect the Random, Irrational and Unknown
In his 2007 book, author Nassim Taleb popularized the idea of a “black swan” event – one highly unlikely and unpredictable but potentially extreme in impact. Unfortunately, “black swan” events, like the 2008 Great Recession or the housing meltdown, seem to happen more often than would be predicted, partially as a result of hindsight bias which causes us to minimize the variability and volatility of everyday events.
A good investor recognizes that life does not always play out according to plan. Expect the unexpected. Ask yourself what can go wrong and hedge against it, rather than focus exclusively on what you believe will go right. Remember why we stress the mantra of diversification. It’s not to increase returns; it’s to protect you should events not turn out exactly as you would like.