Published On: June 30, 2020
Written by: Ben Atwater and Matt Malick
“Congratulations. I knew the record would stand until it was broken.” – Yogi Berra
Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. In the era of COVID-19, it is especially important to examine this topic. Depending on the ultimate path of COVID-19, it is likely the psychology of how we adapt and react that will determine its legacy, economic and otherwise.
Hindsight bias is a misconception arising after an occurrence in which we convince ourselves that we always knew the occurrence would take place and we always knew what the ramifications would be. In many cases, we may even go so far as to say we predicted the occurrence and its aftermath.
Hindsight is a behavioral bias under the category of self-deception in behavioral finance. Other self-deception-related behaviors we have explored in this series are overconfidence and self-serving bias. As a matter of fact, one major consequence of hindsight bias is overconfidence.
The more severe an outcome, the more severe the hindsight bias. For example, during the Financial Crisis and Great Recession many people pointed to how they knew it was coming using anecdotal stories about acquaintances (or acquaintances of acquaintances) who could not afford their mortgage.
Given all the feedback we heard post-crisis, our adaptive learning systems struggled to separate what we processed afterward with what we knew before. Said differently, we receive more information after an event takes place which leads us to believe we knew more than we did leading up to the event. The reality is that almost nobody saw the mortgage crisis coming, whereas now most people probably think they did.
Academics have repeatedly proven this phenomenon. For example, before an election they will survey a group and ask them to predict the winner. After the election, the academics will then ask the same group how many of them predicted the winner. A much larger percentage always say they predicted the winner after the election than the percentage of those who predicted the winner before the election.
Of course, there is a narrative component to hindsight bias, in which we seek to frame a complex series of events into a neat little story.
For example, today most consider Apple’s founder Steve Jobs to be one of the great innovative geniuses of our times. From the beginnings of Apple in 1975, to the Macintosh in 1984, to the iPod in 2001, to the iPhone in 2007, to Jobs’ death in October 2011 coinciding with the publication of Walter Isaacson’s authorized biography, the pure brilliance of Steve Jobs seems definitive. And, as such, the idea that Apple was always a great investment and one we all knew about, if only we had acted.
But, as it turned out, it was not quite so simple. The company fired Jobs in 1985 and he did not return until 1997. In 1981, years before Apple fired Jobs, you could have bought the stock for the same price as you could again in 1997 when he ultimately returned.
Even after Jobs’ return, in 2000 Apple experienced a drawdown of 71%, in 2002 a drawdown of 35%, in 2008 a drawdown of 57%, in 2013 a drawdown of 44%, in 2016 a drawdown of 30%, in 2019 a drawdown of 34%, and this year a drawdown of 31%. Although in hindsight Apple seems like an “easy” investment that “anyone” could have made, the reality of the ride was far more jarring and doubtful. But hindsight literally erases all of this. It truly is an amazing human attribute.
Steve Jobs’s genius, the thing we think we knew about all along, is only evident now, in hindsight. Without the amazing success of Apple after Jobs’s return, his renown would be nothing even comparable to what it is today. And, we could even go as far as to say Jobs got a little lucky with the iPod, a product of which the iPhone, iPad and Apple Watch are clearly derivatives.
With hindsight, we have created a narrative around Apple that makes it seem like it was always inevitable, when it was always very much in doubt. Amazingly, given what we know now, it is hard to even see, let alone accept, the reality that observers did not always consider Jobs to be a master and Apple to be destined for tech domination. Much of this is a narrative that commentators constructed after the fact.
Our nature to think we knew things before they happened – even though we rarely do – clearly leads to a tendency toward overconfidence. Understanding that we live in a random and unpredictable world helps clarify that our predictive ability is nothing short of awful. Study after study shows how bad experts are at predicting economic and market events. Accepting that our forecasts have little value should make us more resolute in avoiding them and instead sticking to a discipline that, to the extent possible, removes our bias toward thinking we know the future.