Skip to main content

“I knew it all along” – Avoiding the Hindsight Bias Trap

“I knew it all along” – Avoiding the Hindsight Bias Trap

How many times have you looked back at some event that, at the time, was a surprise but with the benefit of hindsight seemed so obvious? It happens frequently, and the common adage of “hindsight is 20/20” gets repeated all the time. It’s the tendency for people to look back on an event and say “I knew it all along!” In reality it would have been impossible to “know” for sure the outcome until after it occurred.
In investing this also occurs on a regular basis and is known as “hindsight bias.” This bias helps people save face after a bad decision (I knew that was going to happen), and possibly the most dangerous effect in investing is creating over confidence after a series of good decisions, which then leads to excessive risk taking.

For example, over the last 18 months many health care and biotech stocks have been soaring. Fifty, seventy-five and even one hundred percent gains in a short period of time have been common. With hindsight bias at work, investors can fall into the trap of thinking the reason this sector has done so well is obvious, and have a false impression that this is what will happen going forward. A large portion of their portfolio gets allocated to one sector because they believe their predictive skills are finely tuned. Too much confidence in one’s predictive ability can be harmful to one’s wealth.

Another great example is when market “bubbles” burst. Going back to the dot-com crash of the early 2000’s, or the financial melt-down of 2008 it’s very common to hear phrases like “everyone knew it was going to crash,” or “of course the bubble burst.” However, in the midst of those events it is never that clear.

One of the ways to become a better investor is to learn from past investment mistakes. Hindsight bias can get in the way of that. After the fact it’s very easy for people to attribute the wrong reasons why an investment didn’t go well and, conversely give the wrong reasons why a certain investment did very well.

A good way to overcome this bias is to keep notes at the moments you are making your investment decisions. Do your analysis, write down the reasons why something is being bought or sold and keep a journal of your decisions. This way you can look back and read your actual notes from months and years ago, and not be subject to hindsight bias’ revisionary history.

This also reinforces the idea that investing process trumps investment product. The focus should be on the process of how you make your investment decisions, and by fine-tuning, practicing, and continually improving the way you make your investment decisions your track record will improve and you will see a bright investment future.

4 Keys to Achieving Better 401k Results

4 Keys to Achieving Better 401k Results

There’s no time quite like summer to find fun ways to spend money. we may be wrong, but we’re pretty sure that getting better 401k results rarely – if ever – makes the top five of the “fun” things to think about doing with your money while on vacation. But the truth is, even though you’re taking time off, your retirement account is not. The market’s changing, your plan offerings may be changing, and your goals may be, too. With just a few minutes of effort (really, just minutes), you can quickly assess if you’re on track to the ultimate vacation from work down the road. Here’s what I recommend:

REVIEW YOUR CONTRIBUTION RATE

With the decrease and elimination of many pension plans, many advisors suggest saving at least 15 percent of your pre-tax income to be able to replace your working income in retirement. If you aren’t at that level, set a course to get there. Pick regular intervals (every six months or raise time) and commit to add an additional percent or three or four to get to that 15 percent ASAP.

MAKE SURE YOU’RE GETTING THE MATCH

If you only do one thing, this is it. Make sure you are contributing enough to get any employer match that may be offered. If your employer offers a 5 percent dollar-for-dollar match and you are only putting in 3 percent of your pay, you are literally letting “free” money slip through your fingers. By getting every dollar in company match, you double your contribution rate without lifting a finger.

REVIEW YOUR CURRENT ALLOCATION VERSUS WHAT YOU WANT YOUR ACTUAL ALLOCATION TO BE

Over the last few years (particularly last year) the stock market has had very strong gains. If you haven’t looked at your allocations in a few years, things may have shifted. What was once a 70 percent stock fund allocation may not be sitting above 80 percent. While growth is good, it does put you at risk of having too many nest eggs in one basket. If the market suddenly turns, your exposure is now greater than what you may have intended. A quick look and rebalance of your allocations can reduce your risk and protect your savings.

REVIEW YOUR PLAN OFFERINGS

Make sure you’re familiar with any new features that may have been added to your plan, that you should be taking advantage of. Often new funds are added that may be better performing than previous funds or represent asset classes that didn’t exist in the past. Another new feature to look for is auto-escalation. This feature automatically increases the percentage of your pay going into the plan on an annual basis. If this is available as an opt-in feature, I strongly encourage electing to use it.

Whether you’re taking a number of extended weekends or a week-long break, use some of that time to review your 401k. What you learn and how you respond could go a long way to helping you enjoy your vacation even more and ensure many more relaxing days in the future.

Planning so you enjoy the wins, and prepare for the losses

Planning so you enjoy the wins, and prepare for the losses

Last year was a great year for U.S. stock markets, with all the major indexes up over 25 percent for the year. While this year has not been quite as strong, the major averages are all in positive territory and new all-time highs are being made on a regular basis. That leaves a lot of investors feeling pretty confident.

It’s in periods like this that we hear a lot of people taking a buy-and-hold approach; the idea being you simply ride the market up, ride it down during bad times, and hope that when it’s time for you to start using your investments it’s not down too much. This is not our preferred strategy – in fact, we fail to see much strategy in the approach at all.

Here’s why:

It’s been six years since the S&P 500 has suffered a down year. History shows us that on average the US stock markets go down on a calendar year basis every five or six years. Guess what folks. We’re there. Does that mean we think the bottom has to fall out or that the market is going to crash next week? The answer is “no” on both accounts.

What we do think is that we have enjoyed fantastic gains since the market lows in early 2009 and that a bit of expectation tempering is in order. That includes re-visiting what steps you’re going to be taken when the market does drop. And, yes, when. It’s not a matter of “if” the market will drop but rather “when.” You want your defensive strategy in place before the things start to turn. Having a pre-set strategy helps ensure the actions you take are truly precautionary rather than reactionary.

One of the most common investment defenses is the use of stop-loss orders. A stop-loss order establishes a point at which you will sell off a falling investment. However, if you actively use stop-loss orders, you want to make sure your stop-loss points are where they should be, especially for investments that have been making great gains. As stock prices run up, your stops should be adjusted so any significant gains made aren’t lost in a quick tumble. Often investors will set what are referred to as trailing stops. Set at a defined percentage away from the current market price of an investment, trailing stops essentially make automatic stop-loss adjustments for you.

Another defensive approach is to sort your holdings by relative performance and then sell your laggards and let your winners continue to run. In other words, if it ain’t broke don’t fix it but if it is broke, get rid of it.

If you’re looking to get into the market rather than exit, a good defensive is strategy is what’s called dollar cost averaging (DCA). This refers to the practice of buying a fixed dollar amount of a particular investment on a regular schedule. For the sake of example, let’s say $40,000, spread out in $10,000 increments per month over the next four months. If the price during your first purchase month is $10, then $9 in the second, $8 in the third, and $7 in the fourth, you actually end up purchasing more shares with the same $40,000 than you would had you bought it all in the first month. Plus, the average cost per share across the four months would be lower than it was in the first month ($8.50 v. $10). In this way, DCA lessens the risk of jumping in with both feet a market high.

In some ways, investing is a lot like a team sport that has both an offensive and defensive squad. While it’s great to have offensive control, it would be foolish to begin a game without a ready defense. You can never really be sure when the tables or momentum are going to turn. But unlike a friendly flag football game where a loss might leave you limping home with a bruised ankle and ego, the results of failing to protect your investments with a strong defensive strategy can be much more significant and longer lasting.

My advice is to enjoy the wins but to prepare for the losses. While losing at anything will never be fun, with adequate preparation and planning you’ll not only survive the losses but will be in a better position to get back in the game than those who failed to prepare.