How to avoid being tricked by hindsight bias
By James Parkyn
In late 2021, Wall Street Journal personal finance columnist Jason Zweig asked readers to guess how several financial markets would perform in the year to come as well as where interest rates would at the end of the year.
The following December, Zweig surveyed the same readers again. This time, he asked them to try to recall what they’d predicted the previous year. Then, he compared their recollections to what actually happened in 2022.
He called this little quiz the Hindsight Bias Buster, so it should come as no surprise that readers were way off when they tried to remember what they’d predicted a year earlier.
You will recall that 2022 was a terrible year for investors, marked by soaring interest rates and double-digit losses in both the U.S. stock and bond markets. When Zweig’s readers thought back to their predictions, they remembered being far less bullish at the start the year than they actually had been in real time.
The reason for the discrepancy can be attributed to what behavioural psychologists call hindsight bias. It’s when your knowledge of what actually happened shapes your beliefs about what you’d predicted would happen. As Zweig explains: “It makes us all think we had a better idea of how the past year would unfold than we really did—which, in turn, makes us more confident in our hunches about this year than we probably should be.”
Let’s see how this might play out with regard to the year just past and this year. After a strong 2023 in the markets, it may be difficult to remember that many observers were making gloomy predictions at the beginning of the year. Back then, they forecast that high interest rates would cause a recession that would, in turn, hurt the markets. In fact, the economy proved highly resilient and the prospect of falling interest rates sparked a massive stock market rally at year-end.
Today, it would be natural to fool yourself into thinking you knew all along that the markets would bounce back in 2023. And this distorted hindsight could cause you to become overconfident in guessing how 2024 will unfold. However, the bottom line, as we often remind readers, is that we have no way of predicting what the future holds.
A closely related psychological pitfall to hindsight bias is recency bias. It’s the tendency to give more weight to occurrences in the recent past. For example, a soaring U.S. stock market in the last year might lead you to want to bail out of other global markets and put all your chips into equities south of the border.
If we look further back in the history, we will see the danger of this kind of thinking. For example, following the exceptional run-up in the U.S. market during the dot.com era of the 90s, investors suffered through 2000-2009, a period that came to be known as “the lost decade” for U.S. stocks. In those years, the S&P 500 Index recorded one of its worst 10-year performances with an annualized compound return of minus 0.95%, according to Dimensional Fund Advisors.
What can we say about 2024 without making predictions? Higher interest rates have brightened the long-term picture for investors. Of course, that doesn’t necessarily mean 2024 will be a positive year for stocks or bonds, but as Vanguard noted in its 2024 outlook: “For well-diversified investors, the permanence of higher real interest rates is a welcome development. It provides a solid foundation for long-term risk-adjusted returns.”
The antidote to both hindsight bias and recency bias is a sound financial plan built upon a broadly diversified portfolio that reflects your risk tolerance. Then, your job is to remain invested through good times and bad, patiently allowing the markets to do their work over time.
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