How to Prevent Hindsight Bias from Weakening Your Investment Plan
Discover the Financial Planning Process That Locks Costly Emotions in a Box
“They should have known.”
That’s a common reaction whenever something terrible happens. We look for someone to blame, and the blame eventually falls on whoever ‘should have known’ of the impending threat. The same hindsight bias runs rampant in investment planning.
When a stock market crash happens, or a company goes under or falls in value too fast for people to react in time, investors look for causes, hoping for a way to see it in advance the next time. They regret not having spotted the warning signs while it still could have made a difference.
Hindsight bias makes past events look more predictable than they actually were. In investing, as Breaking Down Finance puts it, this produces a parallel outcome. It “deludes us into thinking that future events are more predictable than they really are. This way, hindsight bias has the tendency to make investors overconfident.”
The last thing you want is an overconfident financial advisor.
Studies of Hindsight Bias in Investing
A 2009 study into hindsight bias and investing performed several experiments in an attempt to quantify the effects of the bias on investment decisions.
The overall conclusion was ominous for anyone picking their financial advisor by drawing names out of a hat:
Hindsight biased investors – after being shown the history of market volatility – will continue to underestimate it and actually perform worse.
Think about this for a minute.
This means you have a group of people who are confident they know how to bet on the stock market. And yet after being shown real history, real data of market volatility, their investment choices continued on as before – assuming a steady increase in equities. And their outcomes got continually worse.
For instance, the authors studied 66 students at Mannheim University, and found that hindsight bias actually reduced the students’ expectations of future volatility.
So they saw the data. They understood what caused previous periods of volatility. This led them to think they understood those causes and could correctly spot them in the future. Thus, since they didn’t see those causes on the horizon, they operated as if everything would be fine.
Similarly, the authors looked at 85 investment bankers, and found that those with greater degrees of hindsight bias performed worse.
When it comes to hindsight bias, it seems knowledge is NOT power.
Lessons for Investors Wary of Hindsight Bias
You are just as vulnerable to hindsight bias as anyone else. It’s an easy trap to fall in, especially in matters and issues that you care about most. Such as investing.
Here are three lessons you can apply as you look for a financial advisor who will be more likely to avoid letting hindsight bias interfere with his decisions made on your behalf.
1. You Cannot Rely on Past Performance
This holds true for both strong and weak performance.
An investor might look back on a period of bullish markets, study and discover valid explanations for those trends, and then believe she understands what caused them. But even if her understanding is correct – and it probably is – there’s no reason to believe those same circumstances will produce the same results next time.
But her resulting overconfidence that she can ‘call it’ next time will actually lead her to make worse investment decisions.
2. You Cannot Rely on Causes of Past Market Downturns
Likewise, an investor studying the causes of market crashes and downturns is vulnerable to the same overconfidence.
Our inability to see things as they really are, when it comes to investing, must keep us humble. The moment an investor believes he can predict or time the market because he understands something from history, he is at risk of employing hindsight bias. And the research above suggests his performance will be worse, not the same and not better, if he persists in that approach.
3. Be Wary of Financial Advisors Who Don’t Consider Market Volatility
One of the best questions you can ask a prospective financial advisor is:
“How do you incorporate market volatility into your financial planning methods?”
Volatility is certain to come. In fact, it happens almost every year in the short term. It’s quite common to observe drops of more than 10% in the same year you see gains of 10%. But it happens over the long term too. The market will not go up every year.
It’s commonly stated that over time, markets always increase. The problem is, how long of a time period must pass before that belief remains true? If you were unlucky enough to retire right before the dotcom crash or the 2008 Great Recession, you gained a whole new perspective about how markets always go up.
ASK your advisor how they plan ahead for market volatility. If they have no answer, look for another advisor. Stick with that person at your own great peril.
How to ‘Beat’ Hindsight Bias in Investment Planning
Can you really beat hindsight bias? Yes, if your advisor has built a process so as to avoid the risks of it. Here’s how Pillar avoids falling into the trap of overconfidence caused by hindsight bias:
1. Healthy Asset Allocation Tied to the Investor’s Goals
Asset allocation with low-cost funds and regular rebalancing, according to Yale Endowment Fund Manager David Swensen, is “the most sensible approach” if you truly want to maximize your long term investment performance. “You’ll end up beating the overwhelming majority of participants in the financial markets.”
Swensen took Yale’s fund from $1 billion to $22.9 billion in just over 20 years – through two recessions and Black Monday. So he knows a few things.
Why is asset allocation so important? Because it helps you keep emotions out of your investment decisions. The stock market is soaring, you might think, and your portfolio is tilting toward equities because they’re making so much money. “Maybe I should just let it keep growing,” you will be tempted to think (and so will your financial advisor if you have one who gives in to hindsight bias).
But regardless of how well or how badly the market might be performing, you must take that money out and rebalance to the pre-planned ratios of stocks, bonds, and cash. If you follow the plan, which was developed based on more than hunches and whims, you will succeed.
2. Don’t Panic When Market Volatility Happens
“Stay the course” is the standard advice here, and you should follow it.
It can be tough to watch your account balances drop during a downturn, but you must keep the long term view in mind. You must trust the plan, and the reasons it was developed.
3. Employ a Non-Emotional, Data-Driven Financial Planning Process
Here’s where most investors – and most financial planners – fall short.
Earlier I mentioned the importance of trusting the plan. But if your plan isn’t rock solid dependable, then you won’t feel confident in leaning on it when times get tough.
Pillar has developed a time-tested planning process that maximizes performance and tailors the outcome to each individual investor. Our planning process is why we only work with high net worth investors with a bare minimum of $1 million and up to $400 million in liquid investable assets. It takes all the fear and uncertainty out of your mind.
How does it work?
Very briefly, our approach doesn’t rely on projected gains, and we do not build your retirement plan around such an unreliable indictor. No one knows how the market will perform in the next twenty years. With the impending uncertainty of climate change, baby boomer retirements, Medicare and Social Security running out of money, and so many other bubbles we aren’t even aware of – no one can predict where the market will go.
Yet, most financial planners make projections about future market growth anyway, based on historical averages. It’s not a reliable approach.
Pillar uses a different approach. We begin with historical data going back about 100 years, before the Great Depression. We’ve analyzed how the market responded to every stress point, every period of growth, every national and world event, every period of inflation, every war, every culture-shifting innovation like the advent of television and the birth of the internet.
With 100 years of data that incorporates the market’s response history to volatility, we then run 1000 simulations through that model – using your custom designed life-goals analysis as well as your financial portfolio – and watch how they perform.
Each simulation acts as a hypothetical market-shifting event. Some positive. Some negative. Some disastrous. Some more disastrous than anything that’s ever happened in history, such as two back to back recessions.
If your portfolio holds up in 75-90% of those ‘What If’ simulations, we deem your portfolio healthy, and you can relax. If your confidence level falls outside 75% and 90%, we make targeted adjustments to your plan, re-run the 1000 simulations, and keep doing this until you’re back within the 75-90 range, what we call the Comfort Zone.
Do you see how this approach eliminates hindsight bias? It both removes emotion and forces healthy asset allocation.
Even if markets are plunging, if your portfolio remains within the Comfort Zone – which is tied intimately to your own personal life goals – then you know you’re okay. And if you fall outside of the Zone, there’s no need to panic. You just make a few adjustments until you’ve restored your long term stability.
There is no consideration given to the specific causes of recent events, media hyperventilating, or how we can better predict them next time. Our approach is one of humble respect for the power of the market.
Learn More about Our Hindsight Bias-Resistant Planning Process
I have much more I could say about this. This was just a quick overview of a very detailed process we’ve fine-tuned and perfected over 30 years of experience as wealth managers.
Want to see if your portfolio lies within the Comfort Zone?
Request a free portfolio evaluation meeting, and see if you’re in the Zone.