Ep. 49: Hindsight Bias & Investing

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Welcome back to Money Matter, My name is Michael and I’m here to guide you in becoming a better and more confident investor. In this episode, I want to touch on hindsight bias and how it can affect your investment behavior and therefore your overall financial plan.

I have fallen victim to hindsight bias, just as you have, and anyone you’ve ever met. It’s human nature. Hindsight bias is a psychological phenomenon that allows people to convince themselves after an event that they had accurately predicted before it happened. And this topic is being studied more and more in behavioral economics because it is a common failing of individual investors. It’s when you tell yourself, I knew this would happen. Or, Of course, I saw this coming!

From decisionlab.com – they ran a story why do we see unpredictable events as predictable after they occur? And in that, they touch research done by Roese and Vohns which surrounds the subject on hindsight bias stating we have three main go-to creations we make up when looking back into the past to help make sense of the present. Or at least help us feel better about our decisions. And I see this happen with not only myself but with clients all the time. The first is Cognitive Bias.

This is where we ultimately distort our memory of past events by creating these narratives through selective memories that help us make sense of the information that we already have in what they call “sensemaking”. Such as when an investment is falling, you might just reach back and recall the down days and say why didn’t I sell?! I saw this coming. Even though there have historically been way more positive days for that stock position than negative.  

The next is Metacognitive Bias which is when we think about our thoughts themselves we find it easy to just use the past thoughts or judgment we may have had to confirm what’s happening today. This is why it’s easier for our minds to make sense of an event that’s happened in retrospect than when it was happening in the present time. I’ve seen a lot of irrational trading going on these past few months and when it’s happening in real-time, I find it at times hard to diagnose with accuracy what’s the driving force here. Then once all the facts are in and I’m looking in the rearview, I tell myself “naturally that was bound to happen” almost as I knew it all along.

And lastly, you have Motivational Bias. This brings investors comfort to what’s happening. This can motive us to see unpredictable events as predictable. Makes you feel warm inside. Like when you purchase an individual stock or a fund, and it instantly goes up over the next few months. This makes you feel good, and you secretly reward yourself with the notion of – of course, It’s going up, that’s why I purchased it! But the reality of investing is that over the short-term markets are irrational and are essentially a voting machine on the underlining optimism of the investors.

Why is this important when investing? It’s because hindsight bias causes investors to believe they are better at predicting capital markets than they truly are. Don’t mistake luck from brains! As I’ve seen this overconfidence go to investor’s heads where they start to make poor decisions. Or sometimes blame others for poor decisions. I know I’ve been on the receiving end of a few of those conversations where we have to go back to the drawing board of the financial plan that we’ve created to re-reference the decisions we’ve made, to make sure we are where we planned we would be. And it’s in there I want to help arm you with some psychological ammunition to combat hindsight bias in your own decision-making.  

First off stop with the “woulda, coulda, shoulda” game. I know it makes you feel more justified in what’s happening. I know I’ve left some money on the table not getting out early enough, or selling too early. I accept that that’s the name of the game and sometimes I’m going to be wrong. But like my father says “It’s better to be early than late”.

Secondly – Start keeping track of past events or decisions. If you are serious about investing and educating yourself to become a better and more confident investor, pay attention to why you’re doing, current events, and reactions to them. I keep an investment journal myself. Knowing that I’ll be doing this career for the next three or more decades helping people and studying capital markets, I want to be able to look back to the 2018 correction, or this recent pandemic, and relieve how I felt and my thoughts on what was happening. Writing things down helps me articulate my thoughts because you literally have to put it all out there on the page.

Lastly – Be a rational investor and think about what you’re signing up for when you’re investing. You know stock markets have historically gone up a lot over the long-term, but have also gone down a lot in the short-term. Some of those pull-backs were caused by black swan events, and other events the brightest investment minds didn’t see it coming! So basically what I’m saying is to set expectations. Run through a few scenarios in your mind of what can happen, then whatever does happen it’s easier for you to think clearly about it and not get your emotions involved.

If you’re having trouble setting expectations and want to have a conversation about you and your financial goals and concerns, know that I’m here to help. Thank you for watching this video and as always I appreciate you giving your finances the attention that they deserve.