Why Hindsight Bias is Dangerous in Investing
Whether it’s discussing the results of a sports game with friends or hearing television personalities talk about world events, we’re constantly inundated with people who proclaim they “knew it all along.” This propensity to look into the past and think we can connect the dots is known as hindsight bias. While it can be amusing to look back at the predictability of events, this bias leads to flawed thinking and poor decision-making, and it can be very dangerous in investing.
Read on to learn about what hindsight bias is, and how to avoid its effects:
How the hindsight bias tricks your mind
When events have already happened, following the breadcrumbs and seeing what led to them occurring is remarkably simple. When you already know the outcome of an event, it’s easy to discover its narrative. Accurately predicting the future, however, is an entirely other matter.
This bias leads us to have a false sense of confidence in our ability to predict events and make smart decisions. It often tempts us to make bold forecasts and lulls us into a false sense of security about the likelihood of occurrences.
How hindsight bias affects your investing
This bias often rears its ugly head when your investments are doing well. Often, you’ll attribute it to your ability to connect the dots, and overestimate your ability to pick more future “winners.” However, choosing a single investment or asset class can be akin to gambling, because it’s impossible to predict with certainty which investment be a winner in the near-future.
Take emerging market equities, for instance. An investor who looked at the double-digit performance of emerging-market stocks from 2005 to 2007 might have deduced that 2008 would have been a great year to put everything into this market. To say the very least, this investor would have been disappointed to see a -53.2% drop in this market.
While there is myriad of reasons why a stock will move up or down in the future, you’re likely to believe you can accurately predict these changes with ease, when no one actually can with certainty.
Avoiding its dangerous effects
The best defense against this cognitive bias is a long-term investment plan. Prudent investors avoid timing the market and making concentrated bets, and instead harness the power of compound interest and long-term growth. By outlining your long-term investment goals and having a plan in place, you can also avoid the temptation to make short-term (and often irrational) investment decisions.
At LexION Capital, we strictly focus on the math and science of the markets, and we don’t allow cognitive biases to sway our decisions. If you’d like to learn more about our unique approach to long-term investing, let’s have a conversation.