Driving in the Rear View Mirror
Taylor Drake | November 17, 2015
Know Your Biases Series
Admit it. We all do it. Woulda, coulda, shoulda. We all beat ourselves up over the fact that we should have seen it coming. Somehow we knew that the market was going to go (up, down, sideways) and just didn’t take action. It’s what researchers call Hindsight Bias – the belief in retrospect that a particular investment outcome was predictable when in fact it was not.
This bias is often caused by how our memory reconstructs events to “fill in the gaps” with what we prefer to believe, and tends to lead us to conclude that what has already happened was inevitable from the beginning.
In an interesting study conducted by Baruch Fischhoff, subjects were asked general knowledge questions from encyclopedias and almanacs. After telling them the correct answers, Fischhoff later asked them to recall from memory their original responses. The results are instructive: in general, people overestimated the quality of their initial responses and downplayed or outright forgot about their mistaken answers.
In the investment realm hindsight bias is exhibited in people who tell you all about their “winners” and conveniently forget to mention their “losers”. They also tend to explain their winners as the result of keen foresight and brilliant tactical moves, while losers are described as avoidable blunders that they had rather not talk about.
In a more recent concrete example, hindsight bias would lead us to believe in 2015 that the bull market run in US stocks over the past 4 years was entirely predictable and we should have had a greater allocation to that asset class. Somehow we should have seen it coming. Similarly, it would lead us to conclude that the struggles of the emerging markets over the same time period were foreseeable and a foregone conclusion.
A close cousin of hindsight bias is Recency Bias. This is our tendency as humans, when making decisions, to place greater emphasis on recent information and observations and place less weight on older information and data that might not be so readily recalled from the past.
Suppose, for example, that all cars are either red or green. Over the course of a week of driving you see equal numbers of red and green cars. However, because you see more red cars during the last few days of the week, you believe that you have actually seen more red cars during the course of the entire week. This is recency bias.
As investors we tend to project forward recent trends and place less weight on more historical data. This is the urge to pick mutual funds and asset classes that have done well over the past few months or years and shy aware from those areas that have not done as well. As we know, asset class returns fluctuate wildly from year to year, and how well an asset class has done recently has little or no bearing on forward-looking returns.
Understanding the biases that we all typically have as humans is a critical to avoiding mistakes as investors. When we lose long-term perspective (Recency Bias) or believe that events are more predictable than they actually are (Hindsight Bias), then we will likely react in ways that are not optimal to our long-term financial health.
In my training as a private pilot, I was taught that there are certain hazardous attitudes that can get a pilot into trouble. For example one of these attitudes is a “macho” sense that leads pilots to take inordinate risks (think Top Gun where risk-taking is glorified). We were also taught an antidotal phrase to memorize and recall should we find ourselves tempted to engage in such behaviors. In this case, the antidote is: “Taking chances is foolish.”
Similarly, when it comes to investments we can overcome some of the hazardous biases we all have as humans by perhaps developing our own antidote. May I suggest:
“A long-term, disciplined plan provides the greatest chance for financial success.”
At Avier, we believe that developing and sticking with a long-term plan is the best medicine for your financial future and a potent antidote to the 24-hour news cycle that bombards us daily. Very little of what passes for news today is anything other than noise that will quickly fade into insignificance. Turn off the tube and live your life. In hindsight, you’ll be happier for having done so.