Beyond fear and greed, other powerful behavioral biases can be found in almost all investors, both private and professional, and are often exhibited by enduring habits and behaviors that are very difficult to self-identify. These biases inform our bad decisions, the mistakes that we continue to make without even realizing that we are making them, let alone why.
Discipline is a valuable commodity when it comes to managing your personal finances, yet we often find ourselves stuck on the bumpy road of bad decision making. We humans are hard-wired for recognizing patterns of behavior and making decisions on the patterns we already know and see, but when it comes to investing real money in real markets, our vision and judgement may be clouded by a number of fact-patterns we don’t anticipate, or worse, decided to ignore because our ego got in the way.
Nobody likes an armchair quarterback, and we don’t want to be accused of trying to be armchair psychologists! Our goal is to examine and understand some of the most prevalent behaviors that can derail your portfolio, offer ways to identify them and seek potential solutions.
Things are so obvious…after the fact.
Smart phones, social media, the wheel, bacon…they are all so obvious now that we can’t even remember life without them. There was a time that these things, and every other thing we now enjoy were not so obvious. But were you able to predict the rise of the things we can’t imagine living without, like your iPhone and Taylor Swift, before they were introduced to mankind?
Hindsight is rooted in a psychological bias that allows us to believe that we viewed past events with more prominence and clarity as when they were happening, falsely leading us to believe that events are more predictable than they really are.
In reality, we often don’t know what is happening even as it’s happening around us, but that doesn’t stop us from believing, after the fact, we had crystal clear insight to those events before they happened! Having a bias toward hindsight can lead us to make overly simple connections between the event’s cause and effect, and somehow make us feel we have predictive powers.
Real trouble begins when investors base today’s decisions on their inaccurate recall of past events. Hindsight, or making decisions using information that can only be found in the rearview mirror, may lead you to excessive risk taking because hindsight can create an illusion of predictive power and an overassment of your skill.
On the other hand, it may also cause you to feel guilty, numb and powerless in making future decisions, wondering if your past successes were due to just plain dumb luck.
Hindsight Bias in Practice
Monday, October 19, 1987 is commonly referred to as Black Monday. World markets were crashing, Starting with Hong Kong, then Europe then the US. The Dow Jones Industrial Average (DJIA) fell 508 points to 1,738, a (22.61%) decline in one day!
But that’s not the story. That very same morning, the Wall Street Journal reported in its Abreast of the Market feature, that the market had reached a “capitulation point” on Friday October 16, when the DJIA fell over a hundred points for the first time ever (108.35).
…we often don’t know what is happening even as it’s happening around us…
A capitulation point! We were in the thick of it, right ahead of the Monday open, and the experts said we had reached the point where we could stop worrying and look for the bounce?
To be fair, not all experts believed we were out of the woods just yet, but this was the Wall Street Journal, the industry bible, in real time saying that we could breathe a little easier, the worst is behind us. The bears had surrendered!
After that, of course, “experts” appeared in the financial press, regaling us with tales of how they saw this one coming. Right. Where were you yesterday? If it were so obvious, why didn’t you short the farm? Seems as though they had a lil’ hindsight bias goin’ on.
We often look back at the events that occurred and search for reasons. Like say a stock market crash. In the aftermath, we seem to have developed a keen ability to know why it happened, even though we didn’t see it coming, and tell ourselves we knew it was coming all along, even though it escaped our notice while it was unfolding!
Overcoming Hindsight Bias
Take notes, leave nothing to chance.
If you did your research prior to making decisions, and kept solid records in your file, you will want to consult your notes, your steps in the process, your decision-making template, if you will.
What is different now that will cause you to see your next decision in its proper context? Try to understand all the potential factors that are making markets do what they are doing, and more importantly, how do these events jibe with the timing of your next decision?
No, I am not condoning market timing; rather, ask the question: what is happening this time around that would have me accelerate or decelerate my long-term wealth creation decisions?
Many times, when we are seeking wisdom and guidance for future decisions we would be well to revisit our past decisions. At that time, did we have an awareness of how and why we made those decisions that turned out well? Or poorly? This is not hindsight, rather it is revisiting the processes that continue to work for us.
Investment markets are often random and results are unknowable, but we can control the things we can control, that is, our own investment decision process.
Consider drafting an Investment Policy Statement (IPS). Its a document that every professional investor uses to as their decision making template. Properly written, it will lay out issues such as risks that you find acceptable, the required return rates you need to make your plan successful, the time frames involved, and other parameters by which you will navigate your ship.
Investing within the confines of your IPS can help you avoid making random portfolio decisions and strive for more predictable outcomes. It can keep you honest in refraining from making an impulse buy. Leave impulse buying for the Chapstick and National Enquirer when you’re checking out the groceries. There is no room for impulse in investing, and hindsight can feed those nasty impulses in a very destructive way.
And remember that even with all your vigorous planning, the markets can make you remember, in an instant, just how human you are: