How often have you looked back at an event and told yourself “I knew it” -- even if you didn’t act on that prediction?
Hindsight bias can lead to faulty decision-making such as overlooking the benefits of diversification.
People tend to forget about “hot tips” that didn't work out and focus on outcomes that fit their narrative.
As with all behavioral biases, the key to overcoming hindsight bias is to keep your emotions in check when investing your money.
Managing our investment behavior and preventing our own biases from influencing our investment decisions is crucial to success. The first step is to recognize the different types of biases we have, so we can identify them and prevent them from influencing our actions in the future. In my last post, I wrote about familiarity bias and the importance of not letting emotional decisions impact your investment strategy; in this post, I’ll discuss hindsight bias.
In the 1970s, behavioral economists identified hindsight bias as a psychological phenomenon in which a person looks back at an event and believes they successfully predicted the outcome -- even if they failed to act on that prediction. Unfortunately, hindsight bias leads people to think that their judgment is better than it is, and it commonly derails many investors.
I think of Hindsight Bias as the “I knew it all along” effect in which people perceive events as having been predictable after they already occurred. Past events seem easy to predict, so shouldn’t future events be predictable? Alas, they’re not.
It's amazing how often people just look at things with 20/20 hindsight and say: “I should have overweighted toward XYZ stock this year.” Well, that’s a great insight into past returns, but what's going to happen next? The bottom line is nobody knows. That's the reason for having a properly diversified portfolio. You never know which areas of the vast investment landscape are going to be the best performing and which areas are going to be struggling.
Predicting interest rates is another good example. Some investors may be wishing today that they invested all their money into short-term CDs and money markets over the past 18 months as rates were rising steadily. But before the Fed’s recent rate hiking cycle, rates on money markets and CDs were near historical lows and not paying much at all. That’s hindsight bias. Outcomes seem easy to predict when you're looking backward. But just because something happened in the past doesn’t mean it’s guaranteed to happen in the future.
The Challenge With Hindsight Bias
Hindsight bias often leads to faulty decision-making such as overlooking the benefits of diversification and ignoring failed predictions. When it comes to overlooking diversification, investors might regret that they didn’t concentrate their investments on a particular asset class that has performed well recently. But if they review the mid-term and long-term performance of that asset class, they’ll see diversification as a fundamental risk management strategy offering better returns.
When it comes to ignoring failed predictions, people often forget about those “hot tips” that didn’t work out and focus only on the outcome that fits their narrative. As a result, they might continue to speculate, which is damaging to their long-term investment returns. By staying well-diversified, you can expect a U.S. stock portfolio to average about 10% per year over time. Being diversified helps you sidestep the risk of overconcentrating in one sector or one individual stock that could ultimately derail long-term portfolio returns over time.
Diversification allows you to reduce your risk of total loss while still providing the returns you need to grow your wealth and live your life. If you do the compounding, 10% a year means your portfolio is doubling every 7.2 years provided you stay invested. Not too shabby.
A lot of hindsight bias stems from people’s inherent stock-picking mentality as their approach to investing. They don't realize that acting on a “hot tip” is not investing; it’s speculation and that’s not a strategy for getting you to your long-term goals. Investing should not feel like gambling. It should not be exciting. It should be as boring as watching paint dry.
So, let’s go back to those tempting short term interest rates. Five percent is a great yield for a low-risk, short-term investment, especially after so many years of being in an ultra-low interest rate environment. By all means, set aside enough for your short-term needs in CDs, money markets, or Treasury bills. However, short-term interest rates could be lower in the future when the Fed recalibrates its rate-setting approach. Further, 5% is only delivering about half of the expected long-term returns from a diversified U.S. stock portfolio. So, after you’ve met your short-term needs, investing the rest in stocks or other riskier assets for future needs makes the most sense. You have a longer period so you can afford to take on more risk. Even if you lose money in Year One, there’s a high probability that you’ll eventually make money and have more in future years.
Hindsight bias comes back to the idea of trying to time the market and predict the future. Nobody can successfully predict the future consistently. You’ll never time the market properly whether we’re talking about stocks or trying to guess the direction of interest rates. That’s why it’s so important to have a disciplined strategy that is based on science, not speculation. Sticking with a strategy through volatile times is the key to investment success.
There are several other investment biases I plan on discussing as part of this blog series. The key throughout is to manage your emotions when investing your money. This is one of the main benefits Novi provides to clients. If you or someone close to you has questions about their investment strategy, asset allocation, or retirement readiness, please don’t hesitate to reach out. We are happy to help.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth Partners.