Hindsight Bias: Why Every Market Move Looks Obvious Afterward (EP.262)

0:29We all need to make smart decisions with our money. stock, sector, or strategy was clearly the one to own. And after the fact, it's easy for investors to say, I knew that was going to happen. But obvious in hindsight is not the same as predictable in real time. That retroactive certainty is hindsight bias, the tendency to see past events as more predictable than they really were. The danger is not just that hindsight bias makes us feel smarter than we are? It can make us trade as if the next turning point will be easier to see than the last one actually was. In a classic 1975 study that I will link to in the show notes at thelongterminvestor.com, a psychologist showed how outcome knowledge changes judgment.

1:13In the study, participants read brief descriptions of real historical events, including military conflicts and diplomatic crises. Some considered the events without knowing how they ended, and others were told the outcome and then asked to judge how likely that outcome would have seemed beforehand. Once people knew the ending, they treated it as more predictable. Knowing the outcome changed how uncertain the beginning felt. Meanwhile, there were some finance researchers that I can link to in the show notes again that found a similar pattern in investing. Participants reviewed investment examples, made forecasts, learned the outcomes, and were later asked to recall their earlier predictions.

1:52Once they knew what had happened, people remembered themselves as having been more confident and more accurate than they really were. The researchers also found that hindsight bias was connected to distorted perceptions of risk and weaker investment performance. The same thing happens outside the lab. Once a market story feels obvious in hindsight, confidence rises. If you believe you knew it, you knew the last bear market was coming, then the next one starts to feel forecastable too. If you believe that you saw the last rally before it happened, then the next rally may feel easier to identify in advance.

2:30That feeling can lead investors to making more timing moves, raising cash in anticipation of a market drop, chasing the asset class that just performed well, or shifting aggressively between sectors at what feels like exactly the right moment. The point is not that market history teaches us nothing. The point is that it usually teaches less certainty than the story we tell afterwards. Hindsight bias also distorts how investors evaluate diversified portfolios. After the fact, it can feel obvious that you should have owned more of the winners and less of the losers. In real time, that was far less clear.

3:05Markets had multiple plausible paths, and the information available at the time did not point to only one outcome. A diversified portfolio will almost always contain something you wish you had not owned and something you wish you had owned more of. And that's not necessarily evidence of a mistake. It's often evidence that diversification is doing what it's supposed to do. Now, financial media can deepen the distortion by telling these clean stories about the past. Interest rates moved, policy changed, earnings reacted, investors rotated, and prices followed. Told after the fact, the sequence can sound orderly and inevitable.

3:42But investors did not experience it that way in real time. They experienced uncertainty, conflicting data, incomplete information, and competing explanations. There are a few habits that you can use to reduce the pull of hindsight bias. One is that before you're making a major portfolio decision, write down four things. What are you doing? Why you're doing it? What you expect to happen? And what would have to be true for you to be wrong? Now, this can apply whether you're changing your allocation, adding a strategy, selling an investment, raising cash, or deciding to sit tight. Later, when you look back, compare those notes with your memory.

4:23You may find that your original view was more uncertain, more conditional, and less confident than you remember. And the gap between your notes and your memory is where hindsight bias lives. It also helps to think in ranges instead of single outcomes. So rather than asking, what do I think will happen? Maybe you could ask, what are the reasonable outcomes and how would my portfolio hold up across them? A portfolio built for only one expected future is pretty fragile. A portfolio built with several possible futures in mind is more likely to survive surprise. And investing always includes surprise.

5:01It includes disappointment. It includes periods when one part of the portfolio looks brilliant and another looks foolish. That doesn't mean the process failed. It may simply mean the future arrived in one of the many ways it could have arrived. A written process makes it easier to stay disciplined through the next cycle, and it gives you something more reliable than memory to consult when the past starts to look cleaner than it really was. The goal is not to predict the next surprise. The goal is to avoid pretending the last one was obvious. If you found this conversation to be interesting, this is actually an excerpt from my new book, The Perfect Portfolio.

5:39It is available now for pre-orders. It comes out September 22nd. But what you might want to do right now is go to theperfectportfoliobook.com, where you can sign up for regular updates about the book's launch, special offers, early excerpts, and invitations to subscriber-only webinars. As always, thanks for listening. And until next time, to long-term investing. Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

6:26This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.