With the recent resurgence of short squeeze favorites GameStop (GME +2.69%) and AMC Entertainment Holdings (AMC +6.21%) as well as crypto underdog Dogecoin (DOGE +0.39%), there is a prevailing feeling that when asset prices rise in a meteoric fashion, it was all knowable in advance. However, research finds that our cognitive biases often serve to cloud our investment decision making.
It's very easy to look at a stock chart and say that we should have bought at the lows and sold at the highs, but before the events have happened, it's far more difficult to accurately forecast price movement. Here we'll discuss the impact of hindsight bias on your investment decisions.
What is hindsight bias?
Hindsight bias, in the financial world, is the tendency for human beings to feel as if they "knew it all along" when it comes to the performance of a particular stock or other investment. Headlines have raved about 1,000%+ returns in several stocks that are fundamentally unsound. But the feeling among novice investors is that these returns were entirely predictable -- and, perhaps more damagingly, that these returns will continue indefinitely into the future.
The reality is that explosive investment returns seem obvious because they've already occurred. We tend to describe outcomes that have already occurred as obvious because that's the version of the future that we have. We tend to ignore the idea that many other outcomes were once possible, and we tend to ignore those potential outcomes because they didn't occur. Instead, as certain asset prices rise, we feel as though this was knowable in advance. Then we experience regret for not investing sooner.
The result of hindsight bias is overconfidence: You might feel as if you have an enhanced ability to predict the future when it comes to your investments. Bitcoin (BTC +1.36%), for example, is up nearly 2,000% over the past two years, and many will claim that this was knowable in advance. But two years ago, Bitcoin had not yet received widespread corporate endorsement, and it had significant risks. Many people had likened its previous parabolic rise to the tulip bulb mania of the 17th century.
As it turned out, Bitcoin rose precipitously in price earlier this year. But again, we should be aware that many outcomes were once possible. Failure to recognize hindsight bias can lead to overconfidently adding to investments that have risen in the recent past, which is more than likely going to produce less than optimal returns.
Image source: Getty Images.
How to avoid it
It's very easy to say that we knew something was going to happen once it's already happened. The best way to remove hindsight bias is to take out the guesswork by considering investments like passive index funds that require no market timing. Index funds tend to be very low cost, require no ongoing management, are incredibly tax efficient, and provide an easy and simple route to portfolio diversification. Broad market index funds also represent a bet on the market as a whole, taking its good and bad years together to produce sustainable long-term returns.
A written investment plan is a very good place to start. Decide on your asset allocation and then on which investments you will use to achieve it. Consider keeping a diary or writing down your thoughts on where the market is going at any given time. Check back a few months later to see if your projections were accurate -- more likely than not, if you do this at least a few times, it will be a humbling exercise.
Don't let your biases stop you
The truth is, most if not all people are extremely susceptible to cognitive biases around investing. Given recent market volatility, it's simply too easy to slip into a state of overconfidence once outcomes have been revealed. And avoiding these biases is difficult. A written plan around your investment philosophy -- one that is written in advance and updated accordingly -- will help to stop any knee-jerk cognitive biases that can get in the way of your long-term investment success.
