Behavioural Finance Part 4 - Hindsight Bias

Initially, I had decided to discuss hindsight bias much later in this series as I had already lined up other "issues" in mind to feature before coming to this one. However, the recent market crash and subsequent bear market have caused a proliferation of hindsight bias theories to emerge, and I felt that it was time to address this very pervasive yet little mentioned topic in order to clear up misconceptions and make us all better investors.

Hindsight bias occurs when one believes (falsely) that one could or should have done something in the past with adequate knowledge only with the benefit of knowing the past (hence, 'hindsight'). I shall give one or two examples here and discuss why this condition is so pervasive and how it affects a majority of investors (including me as well, no one is immune !). As they say, hindsight is always 20/20 while foresight is legally blind, so for those who think the future is clear just by observing the past, they had better take note that this may not always be the case !

One clear example of hindsight bias is how often economists and "expert forecasters" look back and say that they knew something was going to happen, AFTER it happened ! The most recent case of course was the sub-prime debacle which has dragged global stock markets lower and caused the first synchronized global recession since World War II. Looking back, most economists and analysts now proclaim that they "saw it coming" even though I clearly remember that at the time in early and mid-2008, NO ONE saw the collapse of Lehman Brothers and the subsequent drastic fallout from the sub-prime crisis infecting credit markets and causing the credit freeze. Hindsight bias makes things in the past look as though they were "obvious" even though almost no one could have predicted the severe turn of events accurately, and certainly no brokerage firm or analyst correctly predicted the performance of the stock markets as at end-2008, with most having a bullish forecast of on average +10% ! This goes to show that the future can be notoriously difficult to predict and that most people have an inflated opinion of their forecasting abilities solely because of hindsight bias makng them over-confident (another behavioural finance trait, incidentally).

Another pertinent example of hindsight bias which I often get on my blog as well is the constant reminder that I "should have sold at the high and bought back at the low". This is the ultimate form of hindsight bias and concerns looking at past price movements (on a chart) to determine what one SHOULD or WOULD have done. It's a little like saying to accident victims (after the accident) that they should not have gone to so-and-so place so that they could have prevented the accident from occuring. The logic of this flawed argument is obvious - how could one possibly have anticipated something happening in the future and thus have done something to prevent it ? I find this statement usually very laughable, as people are implying that one can time the markets successfully and always buy low and sell high. In reality, it is very difficult to do this consistently (ask anyone who is honest), and some who had done this using valuation metrics (discussed in my previous post) would have also gotten it fairly wrong. An example is those who sold during the early bull market in the early 90's would have stayed sidelined for another 5-6 years as the bull market roared onwards till 2000. So my advice to those who always say one should have sold and bought back lower - how would you know how "low" it goes ? Assuming onoe had purchased a good company at a very good and low price some years back, there is always the chance the bear market may not revisit those amazing lows again. This will only be clear, of course, on hindsight ! In the meantime, the market-timing speculator will miss out on all the dividend payouts while he is not vested, thus reducing his potential gain even further.

As illustrated in the 2 examples above, hindsight bias is a very frequent phenomenon and is pervasive with regards to people who think they can can predict events or forecast the future. With respect to the stock market, nothing is clear and foresight should always be based on an analysis of the best available facts and figures. If one thinks that market timing is a viable strategy (i.e. sell when "high" and buy back when "lower"), then I have to caution that this is and always will be a product of hindsight bias, as one can only tell the highs and lows when one sees a historical chart of share prices.

How can hindsight bias be eliminated in an investor ? Very simple, I believe we should not expect an exceptional return on our investments, but instead be content with a decent rate of return (about 6-8% including dividends) over time. Those who expect an exceptional return will always think of selling at the highs and buying at the lows, and will always lament not doing something they should have done (a form of cognitive dissonance when it comes to actual purchasing). An act of commission is always more destructive than an act of omission, and in the stock market, one is not forgiven for not knowing what he is doing, and this often results in a permanent loss of capital.

At the same time, we should also be humble and accept that the future is often murky, and that we (as rational human beings) are trying out best under the difficult circumstances to maximize our returns and to grow our wealth. Thus, no use kicking yourself over the past and what one should have done as regret is a useless emotion. Instead, one should learn from his mistakes and face the future confidently, as lives must be lived forwards and not backward.