Thursday, February 12, 2015

Psychology of Markets - Hindsight Bias

Over the next several Thursday's, we'll continue looking at various aspects surrounding market/investor psychology and the dramatic effects that emotion and biases have on results.  

Last week we covered confirmation bias.  Today we'll venture down a similar road with hindsight bias which occurs in instances where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.

Simply put: it's the all too common phenomenon of saying to ourselves "I knew it all along!"  

Additionally, we as investors have a powerful tendency to recall our forecasts as being better than they really were.  And that makes a lot of sense from a broader perspective.  If the majority of people were completely honest with themselves when assessing their investment success and acumen there'd likely be far fewer individuals handling their own investments.  Anecdotally, we've seen more than a few cases where investors and advisors alike have rather rosy recollections of their past challenges and failures.  You'd be surprised just how many will tell you they saw the dot com and housing bubbles coming and were able to dutifully protect capital....While true in some instances this certainly was not the majority outcome.

This comes as a timely (or depending on your rooting interests, horrible) opportunity to bring up hindsight bias as we just witnessed a thrilling Super Bowl that ended with tons of criticism, second guessing and Monday Morning Quarterbacking.  The heart of the matter being, as we all know, the Seahawks decision to throw from the Patriot's 1-yard line instead of running Marshawn Lynch.  We'll leave our personal opinion of Pete Carroll's decision out of it since we're Redskins fans and have too many of our own issues to worry over.  

However, what many critics fail to bring into consideration is that Carroll made a very similar decision just before halftime that resulted in a Seahawks touchdown.  With 6 seconds left in the 1st half, Seattle ran a play instead of settling for a field goal attempt.  This was a risky proposition but since it resulted in a touchdown it was casually hailed as the proper call.  Fast forward a few hours and the Patriots are celebrating another title after intercepting Russell Wilson in the end zone. In the minutes, hours and days since the game, the focus on Carroll's play-call has nearly overshadowed the Patriot's victory.  

The common conclusion has been: "Worst coaching decision in football history."

However, if looked at analytically and stripping away any hindsight biases, Carroll seems to have made a reasonable statistical decision. went into fascinating detail looking at the various scenarios surrounding the fateful play.  In fact, their analysis shows Bill Belichick as the coach that made the poor coaching decision based on statistics by not calling time-out.  However, statistics and probabilities do not always make for certainties and viewers/commentators were able to immediately reshape their narratives and declare this a boneheaded play-call.  A call that they surely never would have made if put in that position.

Humans have an innate need to make sense of the things happening around them.  Often times this results in us forming a view that makes events appear as if they were predictable.  There are few places more harmful for hindsight bias to take hold than in investing.  It frequently leads to overconfidence and an oversimplification of outcomes.

When fine tuning your investment process, make sure you're using completely honest assessments and be your own biggest critic.  Acknowledge your successes but examine and really deconstruct your losses.  That's where the best lessons are learned.

And if you're not making this face when reviewing some of your losing trades...'re probably being too easy on yourself.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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