That’s a funny title, isn’t it?
How can you look back at something that hasn’t happened yet? How can we possibly know what’s going to happen socially, economically, and in the stock market from this point?
Now, imagine it’s the year 2025. We’re over the pandemic, we have learned the end result, and we know all the events that have yet to play out. You now think back to the crash of 2020, how you suffered financially, and your behavior as a result of it.
Although it might seem ludicrous looking at what we know today, human nature has it that a lot of people are going to look back and say they knew it all along. When financial advisers and TV experts are going to explain to future clients how their investments were handled during the dark period, many are going to start off with “Of course, I knew that…” and private investors explaining to friends and family how they performed will say “Everyone knew that…”
This will happen no matter how dark or bright the crisis we now face becomes. Crazy, right? Remember, we’re five years into the future. I’ll now explain why this will happen.
Let’s take two examples of possible outcomes from the coronavirus crisis.
The world’s strong isolation measures and lockdowns work to slow the spread of the virus but are postponed again and again. The coronavirus is like a wildfire that continues to put the world to a stop. Continued social distancing and isolation set the world into a deeper recession than anticipated, oil prices remain slumped, and the stock market has not properly discounted what’s to come. We’ll look back in astonishment at the levels of complacency showed by certain citizens and policymakers.
Markets have discounted a much worse scenario than what it comes to. New coronavirus infections peak miles short of what epidemiologists, the World Health Organization, and various experts predict. The doomsday scenario doesn’t come to pass and we start returning to normal much sooner than most expect. Questions will arise about the extreme panic and why policymakers were willing to sacrifice such huge (and certain) costs to overweigh incremental (and uncertain) benefits. We’ll look back in astonishment at the time when stocks plummeted over 30% in short months due to a temporary halt.
A little mental exercise will pose one to think both scenarios fairly likely. Both scenarios will seem more obvious after the fact.
This is because these scenarios are reconstructions of what happened - simplified descriptions of a reality full of uncertainty which no one has any idea about. Our minds tend to forget the level of details around an event from the past, so rather than become recollections, these events tend to become reconstructions made from a combination of what we don’t know now and what we later find out.
What I describe is hindsight bias. It’s also called creeping determinism. It’s the common tendency for people to perceive events that have already happened as having been more predictable than they actually were before the events took place.
As Daniel Kahneman explains it:
What hindsight does is it blinds us to the uncertainty with which we live. That is, we always exaggerate how much certainty there is. Because after the fact, everything is explained. Everything is obvious. And the presence of hindsight in a way mitigates against the careful design of decision making under conditions of uncertainty.
What’s the Big Deal?
Hindsight bias is dangerous because it hinders one from learning from past mistakes. If we feel like we knew it all along, it means we won’t stop to examine why something really happened.
It also leads to miscalculating risk tolerance. The result is overconfidence which leads to bad future decisions and lower returns.
Due to this bias, we tend to view ourselves in a positive light, and we tend to not remember our past mistakes as well as our successes.
"Knowledge of an event’s outcome works as an anchor by which individuals interpret their prior judgments of the event’s likelihood."
Hindsight bias becomes stronger when one has explicitly published one’s opinion of what is going to happen during times of uncertainty. Right now, social media is overwhelmed by ordinary people each having a say on how the current coronavirus situation will evolve, either catastrophically or mildly. A lot are having strong opinions about how others should behave and conduct their daily lives and a lot are strongly suppressing alternative hypotheses from theirs. Frankly, some of it feels like bullying. It’s not pretty to look at.
The problem is that the strongest publicly stated opinion is likely to be subject to the most bias in the future if it turns out as opinionated. This is also termed commitment and consistency, which, if coupled with hindsight bias, is a mind-killer. If an obviously uncertain event turns out as 'predicted' leading to “I told you so!”, that person is very likely to overestimate his judgment the next time. Don't be that guy.
For instance, there are many examples of investors who were successfully able to predict the housing bubble and the ensuing financial crisis who then have gone on to overestimate their ability to consistently predict bubbles, testing their investors' and their own patience - and money.
But This Time is (Not) Different!
Because any prior event is seen as obvious after the fact, hindsight bias leads us to believe that it’s unusual that nobody knows what’s going on at the present time. But that is just baloney.
The uncertainty of what we face now with the coronavirus, oil prices, the highly unusual volatility in Treasury yields, and so forth is undeniably not unusual. If it was, it would mean that we did have an idea of what was going on during prior events such as the financial crisis, the internet bubble, or 9/11. But obviously we didn’t. It’s just hard to remember that we didn’t. I can assure you that monetary and political leaders (superbly) navigated the financial crisis pretty much as blindly as we navigate the whole pandemic scare now.
Like I wrote in a previous Note, the world is in uncharted territory all the time.
What hindsight bias also does is suppress the feeling of fear. Take the financial crisis. The top of the S&P 500 that was hit on February 19th was 115% higher than the top hit in October 2007, just prior to the biggest crisis since the 1930s. When you could double your investment if you bought at the very pre-crisis top by just sitting tight, you tend to forget the agony felt during the downturn. Memory whitewashes misery.
And because we’re over 10 years past the end of the crisis, this has allowed private investors and financial professionals to look back at 2007-2009 as it really was no big deal. And it has allowed wretched excess to again flourish in ridiculous areas such as value-destroying takeover deals and cryptocurrencies.
How to Overcome Hindsight Bias
The obvious (and probably only) way to get around hindsight bias is by documenting your reasoning. Here, it’s very important to be able to put the situation you’re facing on a predictability scale.
Ask yourself: Is the outcome I’m facing at all predictable? If not, the inputs into your forecast really don't matter. And even more importantly, other people’s forecasts and opinions won't matter either. But what is valuable to document here is your feeling about the event. You shouldn’t trust your recollections of how you felt 5 or 10 years down the road. Write down how afraid or equanimous you are right as the event unfolds. Later, look at your account statement whether you sold at the bottom.
If the outcome is predictable, of course, tracking your inputs that went into your prediction of what will happen is important. Subsequent experiences may show that you used wrong (or misunderstood) inputs or assumptions. Perhaps you did use the correct model but were applying it to a mistaken picture of then-current conditions. Documenting this allows you to go back and revise after the fact.
It all leads down to using a decision journal to improve your ability to make decisions over time.
Hindsight is a big deal.
It allows us to keep a coherent view of the world, it blinds us to surprises, it often prevents us from learning the right thing, and it tends to lead us to learn the wrong thing.
In uncertain situations and times of panic, we all make non-optimal decisions. Of course, we do. But it’s important to make rational decisions. There’s always something coming along that we can't anticipate. But rather than blaming the mistake on one's inability to anticipate uncertain outcomes by saying “I knew it! I’ll never make that mistake again”, perhaps the real lesson is that the world is difficult to anticipate.
That’s the lesson. The world is full of surprises.
History shows that everyone who has ever invested during the darkest days of the stock market has ultimately been rewarded. There’s no reason to think this time is different. For more on how to invest intelligently during a market panic, read here.