Embracing Imperfection - Hindsight Bias

OVER-ESTIMATING YOUR ABILITY TO HAVE PREDICTED AN OUTCOME AFTER THE EVENT

New Year's resolutions often involve making promises to ourselves we can never keep. But instead fighting a battle you can't win, you can often get better results by just resolving to be less dumb in certain areas.
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And money is a good place to start.

A really common example for this is our human tendency is to judge how good our retirement savings strategies are by looking at performances on one, two or three-year horizons. We do this because we are wired to be more sensitive to short-term losses than to long-term gains.

This is why much of the financial services industry and media encourage a short-term focus for an audience with a long-term horizon. This is like looking through the wrong end of a telescope. The thing you should be focusing on looks even further away.

The result of this short-term mindset is that investors end up following the herd and buying when things are expensive or panicking and selling when they are cheap.

The less dumb thing is to maintain a level of discipline amid the noise.

Another human tendency — and one linked to our in-built loss aversion — is to be suckers for the supposedly 'free' or discounted offer. Like Homer Simpson, a zero price tag makes us fall for pitches that sell us stuff that is neither necessary nor good for us.

In the world of investment, it's this tendency that attracts people to headlines of high returns without mentioning the risk or those conveniently buried fees, commissions and other costs. Regret lies on the other side of those decisions.

A less dumb thing is to focus on return and risk. They're related. Focusing just on return can lead to a rude shock when risk shows up. Focusing exclusively on risk can lead to disappointment when returns are delivered.

A third tendency among humans is to succumb to what behavioural scientists call "hindsight bias". This is our habit of viewing events as more predictable than they really were. Call it the "I saw it coming" syndrome.
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There is always a lot of this around, with the recent Brexit result being the classic example. Check out these 2 headlines:

​‘SUPER FORECASTERS SEE 23% CHANCE OF BREXIT AS ECONOMY WINS OUT   Bloomberg, May 8, 2016

BREXIT: A DISASTER DECADES IN THE MAKING
Guardian, June 30, 2016

After a result that virtually no-one picked, all of the sudden, it was obvious that it would happen. Everyone's an expert with hindsight!!
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The consequence of hindsight bias for investors is they tend to be forever rewriting history and forever seeking to interpret performance based on what they know now rather than what they knew at the time.
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A less dumb thing is to accept there will always be a level of uncertainty. The future is unknowable. And all we can do as investors is to ensure the risks we take are related to an expected return, that we diversify around those risks as much as possible and that we exercise a level of discipline amid the noise.

It's a way of embracing your imperfection and it's a New Year's resolution you have a chance of sticking to.

This article was produced with the assistance of Dimensional Fund Advisers