How to avoid being tricked by hindsight bias

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.

For more commentary and insights on investing and personal finance, be sure to listen to our latest Capital Topics podcast and subscribe to never miss an episode. And download your free copy of our popular eBook Investing Life Skills for Early Savers. It’s designed for young people starting out on their investing journey but its tips apply to investors of every age.

Here’s a better way to think about risk

by James Parkyn

Our job as investment advisors and portfolio managers is to capture returns from global capital markets while controlling portfolio risk. We do this by maximizing diversification, minimizing costs and seeking to make portfolios as tax efficient as possible.

A critical element in this work is matching portfolio risk to our clients’ risk tolerance. Your tolerance for risk depends not only on how comfortable you are with uncertainty, but also your capacity to take risk given your age, financial situation and life goals.

Last spring, Ken French, in association with Dimensional Fund Advisors, published an essay entitled Five Things I Know About Investing. French, a professor at Dartmouth College, is a giant in the world of finance who is best known for his work with Nobel Prize winner Eugene Fama.

The first part of his essay deals with risk. French proposes a definition of risk that steers clear of such technical concepts as volatility, standard deviation and beta. Instead, he defines risk as “uncertainty about lifetime consumption.”

He explains that people invest because they want to use their wealth in the future to achieve important goals like enjoying financial security, supporting the people and causes they care about and retiring comfortably. Risk is uncertainty about how much wealth it will take to achieve those lifetime goals.

“Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation and medical care,” French says. “Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children…Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.”

In this light, the financial author Morgan Housel makes some important observations in his book The Psychology of Money about how risk and unforeseen events can jeopardize your future wealth.

“A plan is only useful if it can survive reality,” Housel writes in this excerpt from his book. “And a future filled with unknowns is everyone’s reality.”

According to Housel, surviving future unknowns to build wealth for lifetime consumption comes down to three things.

• First, more than big returns, you want to be financially unbreakable. In other words, you don’t want to take the kind of risks that will deplete your wealth and prevent you from benefitting from the power of compounding over the long term.

• Second, the most important part of your financial plan is to be prepared for things not to go as planned. You only have to think about the pandemic, the war in Ukraine or rising interest rates to know you should expect the unexpected. “Room for error – often called margin of safety – is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline – anything that lets you live happily with a range of outcomes.”

• Third, Housel writes it’s vital to have a “barbelled personality” – optimistic about the future, but paranoid about what will prevent you from getting there. According to Housel, sensible optimism is a belief that odds are in your favour for things to work out over time even if you know there will be difficulties along the way. To make it to that optimistic future, you have to make prudent decisions and stay the course when things are looking bleak.

I encourage you to read Ken French’s essay to benefit from his other observations about investing. I also invite you to download the latest episode of our Capital Topics podcast where we discuss French’s essay in more detail.  

Ask yourself this simple question before changing your portfolio

by James Parkyn

We know from the field of behavioural finance that people tend to feel the pain of losses much more deeply than the joy of gains. That’s why a bear market like the one we’ve experienced this year can be so hard to take.

When the markets become turbulent, most investors know they should keep a tight rein on their emotions. But in the heat of the action, when markets are sinking, it’s not easy.

There’s just so much uncertainty. You don’t know how bad the bear market will get or how long it will last. And don’t look to the media for help. Stock market commentators tend to focus on the negative and trot out clichés like “It’s a stock-pickers market” or “Buy and hold is dead.”

These bromides encourage people to trade their investments, but if you’re tempted to veer away from your long-term financial plan, ask yourself one simple question: Then what?

Once you make the decision to sell stocks to avoid further losses, what comes next? At some point, you will have to buy back into the market. But how will you know when it’s safe? In the meantime, you risk missing out on returns when the markets rebound.

Or you might be persuaded to purchase an actively managed mutual fund based on its past performance. However, we know that only 18% of actively managed Canadian equity funds outperformed their benchmark over the 10 years to December 2021, according to the S&P SPIVA Canada Scorecard. Actively managed U.S. and international funds have similarly dismal track records.

If the mutual fund you’ve chosen underperforms, then what? Do you go in search of yet another fund in hopes it will do better? Or perhaps you try your hand at picking individual stocks even though we know investors tend to fare even worse when they try this DIY approach.

In an insightful column, David Booth, Executive Chairman of Dimensional Fund Advisors, acknowledges that the uncertainty of the markets and life is highly challenging for people. However, he also observes that with uncertainty comes opportunity.

“Most of what happens in our lives is unpredictable, and it’s impossible to forecast the future,” Booth writes. “But you can live your life fully without knowing what’s going to happen. And you can have a good investment experience without forecasting what the market is going to do, because you’re not trying to guess which companies will succeed and when. You’re investing in the ingenuity of people to solve problems and make their companies run better.”

While the future course of the markets is impossible to predict, we can control how much risk we take; how broadly we diversify our investments; and who we turn to for financial advice.

When our emotions start to boil, we can remind ourselves that the key to investing success is to remain in markets long enough for compounding to work its magic. Blogger Ben Carlson put it this way: “The bedrock of my investment philosophy is based on the idea that it’s best to think and act for the long-term. But you have to survive the short-term to get to the long-term.”

Your goal should be to make decisions based on a well-structured financial plan and a tried-and-tested evidence-based approach to investing.

Then what? Then, you face the future with courage and optimism and let time do its work.

For more insights on how to navigate the markets, please download our eBook the Seven Deadly Sins of Investing. And if you’re not already a listener of our monthly Capital Topics podcast, I encourage you to download the latest episode and subscribe to receive future episodes.

It’s a terrible time to be bailing out of bonds

by James Parkyn

Most readers of this column will be familiar with the unfortunate tendency of some investors to buy high and sell low. They rush into rising markets and flee when they come back to earth.

That’s a pattern we usually see in the stock market, although this year U.S. equity investors have shown patience in the face of falling markets. Where they’ve been running from is the usually staid world of bond funds.

Bond prices have been going through a downturn in 2022 like we haven’t seen in 40 years. Our latest market statistic report shows the total global bond market (hedged to Canadian dollars) was down 12.3% to the end of September, while the Canadian total bond market was down 11.8%.

Those are pretty horrible numbers for what’s supposed to be the safe bucket in your portfolio. Investors in the U.S. have responded by cashing out of bond funds in droves. Morningstar data shows that year-to-date to August 31, US$330 billion had flowed out of U.S. bond mutual funds and ETFs. Surprisingly, the opposite has occurred in Canada where bond mutual funds saw net inflows of $1.3 billion and bond ETFs saw net inflows of $4.5 billion.

The discrepancy in bond fund flows between the two countries is hard to explain; however, Canadian balanced funds—those that hold a mix of stocks and bonds—followed the U.S. pattern, experiencing a net outflow of $6.5 billion for the year.

Those investors who are fleeing bonds are focusing on the short-term pain they’ve experienced from falling fund prices but are missing out on the several reasons why bonds have actually become more attractive this year for long-term investors.

Before we look at those reasons, let’s recall why it’s been such a challenging year for bonds. Coming out of the pandemic, inflation has been surging around the world. That’s prompted central banks, including the Bank of Canada and the U.S. Federal Reserve, to raise interest rates aggressively to cool the economy and bring down inflation.

What’s more, central bankers, led by Fed Chairman Jerome Powell, have also been clear that they will do what it takes to bring price increases under control, meaning they will keep raising rates until the inflation rate comes down to around their target of 2%.

Bond prices are inversely related to interest rates so that when rates rise, bond prices fall. Therefore, rising rates have meant capital losses on bond investments. But when watching bond fund prices drop, it’s important to remember the other side of the equation – falling prices mean bonds are paying higher interest rates, or in industry parlance, they are yielding more.

In fact, rising interest rates are creating a whole new investment landscape from the one we’ve known since the financial crisis of 2008-09. The rock-bottom interest rates we’d become accustomed to are now in the rear-view mirror.

Bonds are generating more interest income than in years past and that increases expected portfolio returns – good news for long-term investors. That’s the first reason why it’s a better time to invest in bonds than it was a year ago.

The second reason is that bonds will continue to be an important diversifier for your portfolio and thus reduce its riskiness – even in periods of rising interest rates.

The stock and bond markets have been relatively well correlated this year – going down in tandem – but that’s a highly unusual occurrence. Bond prices usually have a lower correlation with stocks than most other major asset classes and are also less volatile.

Mark Haefele said in his weekly blog, published on September 26th that History suggests bonds will resume their traditional role as a diversifier. Periods when 12-month rolling total returns fall simultaneously for both stocks and bonds have been followed by periods of strong bond performance. In fact, since 1930, the 12-month bond performance following such periods has been positive 100% of the time.

No one can predict the course of interest rates, as former Bank of England governor Mervyn King has pointed out. However, the picture for bonds has brightened not worsened this year. If anything, investors who reduced their bond holdings in favour equity during the long period of low interest rates may want to revisit their asset allocation.

For more insights into investing and personal finance, please download our Capital Topics podcast.

Will higher interest rates push the economy into recession?

by James Parkyn

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.