PsyFi Search

Sunday 7 August 2011

HONTI #2: Hindsight's Not So Wonderful

Rule #2: Don't forget the past, get yourself some feedback.

"Those who cannot remember the past are doomed to repeat it"; George Santayana, The Life of Reason
The second most dangerous trap any investor can fall into is the “I knew it was going to happen” syndrome: the remarkable ability of people to decide that they can predict the future, but only after that future has already happened: an exercise in futility were it not so damaging to investment prospects. This isn’t just a problem for amateur investors either: studies of investment bankers, for instance, show that those bankers least affected get the best returns: and vice versa1. Overcoming this wilful amnesia is critical to improving investment results.

The issue applies to all sorts of areas of expertise – the CIA, for instance, observes that intelligence “analysts normally overestimate the accuracy of their past judgments”2. As we saw in the wake of 9/11, there was plenty of evidence pointing to the attacks but unfortunately it was only afterwards that it was possible to sift the data, to pick out the relevant information. Failing to understand this difference means that we can’t learn the lessons of the past, because we believe people made avoidable mistakes when, in fact, they didn’t have the right tools for the job.  It's a problem in medical malpractice suits as well, for hopefully obvious reasons: the future's shrowded in uncertainty, the past is obvious in retrospect – everyone knows we cut the wrong leg off after the event.

This problem's known as hindsight bias and it’s a deeply buried psychological issue that’s virtually impossible to overcome directly. When we look back we always think we predicted our present situation when, in reality, we didn’t. This inbuilt tendency to overestimate our ability to predict events means that we’re inherently overconfident about our judgement when it comes to placing bets on what’s going to happen in future. Which is not a good trait for an investor.  It’s easy to show this: write down your predictions about the future trajectory of investment markets today and then write down what actually happened – and then compare the two. After six months you’ll be surprised; after two years you’ll be stunned. You’ll also be a far better investor – but unfortunately you may need a shrink to cope with the fallout.

In fact, if you’re not surprised by what you read in your own diary you’ll almost certainly be seeing a psychiatrist already because you’re probably suffering from depression. It’s an odd, but true, fact that the only people who seem able to avoid bias caused by hindsight are those already deeply sunk in misery. No one’s really sure why this is but a plausible theory is that we have to think we can predict the future because if don’t the whole world is so overwhelming we’re likely to sink into a deep funk3.

So we now believe that the purpose of memory isn’t to allow us to reconstruct the past, but to change our future behaviour, something depressed people find it hard to do4. This means memory's great when it comes to learning not to walk across busy junctions in rush hour, assuming we survive the experience, but less so when it comes to not making investment mistakes: which tend not to happen all at once, but to occur slowly over time, allowing us to boil like frogs in a slowly heated pan of water. 

Hindsight bias would be bad enough anyway, but it’s linked to a nasty associated problem, which is that we habitually overestimate our investment returns. This is extraordinary, given that you’d think it’s purely a matter of measurement, but people are wilfully able to avoid facing up to the consequences of their decisions – one study showed that investors overestimated their performance by 11.5% per year5. Psychologists reckon this is an effect of cognitive dissonance6, where we don’t want to admit to ourselves that we’re not as good as we think we are.

While this avoidance behaviour may be good for our mental balance, for us poor investors it’s a terrible way to proceed – on the assumption that we actually invest to make money7. Every choice we make means making a judgement about an uncertain future and if we’re simply going to blank out our past mistakes we’re never going to get better because hindsight bias will cause a form of investor amnesia where we continue to make investing errors without ever learning from them.

Interestingly there are a few rare areas of expert judgement where the so-called experts do manage to make successful predictions at a rate better than a coin-tossing monkey on a bucking bronco. This is why you shouldn’t bet against geologists or weather forecasters, at least when it comes to geology or weather forecasting8. What both these professions have in common is a focus on clear and fast feedback, so that individuals have no chance to avoid the nasty reality of their mistakes and can calibrate the results of their decisions against real results.  The net effect of this feedback is that they become pretty good at making predictions and, even more importantly, much more comfortable with constantly updating their forecasting models when they inevitably make mistakes. The feedback helps reduce the impact of hindsight bias and cognitive dissonance. If we’re going to become better investors we need to find a way of replicating these feedback mechanisms.

The first thing is to accurately measure returns. If you don’t measure you can’t judge the success of your approach. The second is that you need data to analyse your decisions in the cold light of experience. You need to keep an investment diary9.

A diary doesn’t need to be complex – in fact it absolutely has to be simple, but it needs to cover every trade, with an explanation of the reasoning behind the decision.  You then need to diarise a review of these notes, because simply assuring yourself that you'll do it at some point is a surefire way of never getting around to a cross-check: review decisions every six months and add additional notes about the subsequent performance of the investments and why that performance has diverged from expectations. Sometimes, of course, this'll just because of unpredictable events, because the past is only a rough template for the future – but if your portfolio contains an unusual number of firms afflicted by such problems that, in itself, is an indication of something personally amiss.

This isn’t about beating ourselves up, it’s about making sure we get proper feedback so that we can adjust our mental models.  The challenge is to keep the diary going, especially when it starts to reveal how often we get things wrong – and we get things wrong far more often than we think we do. It isn’t especially pleasant to discover that we’re not the person we like to imagine ourselves to be, and this kind of note-taking makes it hard to hide from ourselves the affects of our judgements; which of course is exactly the point: it forces us to confront the person in the mirror, and adjust our perception of them.

In truth, though, we don’t have much choice if we want to learn how not to invest. If it didn’t hurt to confront our own mistakes and the uncertainty of the future then the mind wouldn’t impose hindsight bias on us anyway, so in this case no pain, no gain isn’t an exhortation to sadomasochism: it’s a necessary step to becoming a better investor.

>> HONTI Home Page

Notes to the article:
  1. This research comes from Bais and Weber: Hindsight bias, risk perception and investment performance - note that more experience doesn't decrease the bias.  As the CIA says - it's "virtually ineradicable": and they ought to know.
  2. From the invaluable online resource on the Psychology of Intelligence Analysis at the CIA's website.  Of course, this could be deliberate misinformation ...
  3. See Depressed Investors Don't Need Feedback, Everyone Else DoesEdward Russo's and Paul Schoemaker's paper on Managing Overconfidence ought to be read by all investors.  And everyone else, really, including bankers, regulators and politicians.  Especially bankers, regulators and politicians.
  4. Baruch Fischoff is essential reading for research into hindsight bias: see the general discussion at the end of the paper Hindsight <> foresight: the effect of outcome knowledge on judgment under uncertainty for a summary of the real problems hindsight bias can cause: "The past is only an imperfect predictor of the future".
  5. This very scary stuff comes from a paper called Why Inexperienced Investors Do Not Learn: They Do Not Know Their Investment Performance.  There's a wider question, about whether experience helps us improve, about which the answer (as note 1 suggests) is ambiguous at best.  Not something to rely on.
  6. See Hindsight Bias for a description of how the bias and cognitive dissonance may (or may not) interact.
  7. Oddly enough this isn't necessarily a given: people collect things for all sorts of reasons and shares in companies are sometimes just another collectable: see Love Your Kids, Not Your Stocks.If you like collecting stocks like stamps then directing yourself to a different sort of collectable and buying an index tracker with the money you save is probably the best idea. 
  8. Russo and Schoemaker, again (see 3).  There's an implicit link here with overconfidence, but the causal links between overconfidence and hindsight bias are fairly clear.  That's not the whole story, though: women are far less overconfident than men.  And generally have better investment returns: see Investors, Embrace Your Feminine Side.
  9. This paper on Improving Judgement in Forecasting by Nigel Harvey is well worth a look, and there are a number of points worth revisiting but "Keep records of forecasts and use them appropriately to obtain feedback" pretty much sums it up. 

No comments:

Post a Comment