Behavioral Pitfalls of Investors – Hindsight Bias | ETF Trends

The following article is Part 1 of a series highlighting and analyzing cognitive errors and emotional biases of investors, a list of which is found in the CFA Institute curriculum for the Level III exam.

By Ryan Gilmer, CFA – VP Investment Management – TOPS ETF Portfolios

“Life can only be understood backwards, but it must be lived forwards.” – Soren Kierkegaard, Danish philosopher

One of the biggest problems with investing is that the future is uncertain. We can estimate, forecast, prognosticate, research, analyze, investigate, and scrutinize the market or a particular investment. Much of this activity is beneficial, but it still can’t bring us to absolute certainty.

Fundamentally, the market hates uncertainty. But, no matter how high a probability may be, we don’t know that something will happen until it happens. When we step back and think about it, the market is made up of millions of participants, each with their own unique goals, perspectives, and attitudes. We can estimate, but how can we know for sure how such a group will behave or what they will buy and sell? Uncertainty always hovers over the investment decisions we make.

Despite this truth, something happens inside an investor’s brain once an event happens. Perhaps the Fed raises interest rates, or the market experiences a correction. Whatever the event, once it happens, it seems so obvious. Investors are convinced that they could have seen it coming. Or sometimes, they convince themselves that they did see it coming beforehand, even if they only saw the chance of it happening in real time.

Think about some of the biggest market events of the past twenty years. Doesn’t it seem obvious in hindsight that investors who piled into tech stocks in the late 1990s were foolish? And yet, lots of people did it, because they thought those stocks would continue to go up. And they did, for a while. At that time, it wasn’t obviously foolish to everyone, because if it were, no one would have done it.

Former Federal Reserve Chairman Alan Greenspan famously warned that the market was “irrationally exuberant” on December 5 th , 1996 – and from the market close that day to the peak on September 1, 2000, the S&P 500 rose an additional 115.75% before reversing. Was he right or wrong? Eventually, he was right, but in hindsight, the timing of his prediction was dead wrong. There were reasons to be concerned, but the market went up for four more years anyway. In fact, when the market bottomed in 2002, it was still higher than on the day Greenspan made his comments.

What about the aftermath of the financial crisis? Hindsight tells us that early March 2009 was the best investment buying opportunity in decades, perhaps in a generation. Except that it wasn’t obvious at the time. Banks were failing. The economy was in a severe recession. How could you have known for sure that everything would turn out the way it did?

The truth is, you couldn’t know for sure. In fact, if the history books (and brokerage statements) were opened and we could see what each person did during those events, the truth would be more evident. Investors didn’t know to sell tech stocks in 2000. And they didn’t know to buy stocks in March 2009. The only way you know for sure is to look backward, which of course, doesn’t help much when trying to look forward.

So, what can investors do about this?

One of the most powerful bias fighting techniques is simply to acknowledge the existence of bias in how we view the world and process information. While this may not eliminate the bias completely, it does provide some benefits in making investment decisions in a forward-looking world:

  • Investors should be able to see both sides of the coin – the bull and bear case for the market, rather than fixating on a “guaranteed” outcome that doesn’t exist (until it’s in the rearview mirror)
  • Investors should let go of the expectation of the perfect portfolio – after all, since we can’t know for sure what will happen, we don’t have to hold ourselves hostage to perfect outcomes
  • Investors should not let surprising or low probability outcomes affect their future investment decisions
  • Investors should avoid chasing investments based on their past performance (in hindsight)
  • Investors should create a framework, with the help of an advisor, to make peace with their investment process beforehand, rather than using hindsight to judge the process after the fact

Hindsight, as they say, is 20/20. But investors who realize they are prone to hindsight bias will be better equipped to handle uncertain outcomes in a market that must be lived forward. Likewise, once hindsight bias is abandoned, investors can be more content with a disciplined long term strategy designed to weather a wide array of market cycles.

This article was written by Ryan Gilmer, CFA, who is Vice President – Investment Management at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.


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