How Hindsight Bias is hazardous to clients' wealth

Sep 01, 2016

This post was written by Michael Pompian for Morningstar Advisor.comwhere it initially appeared.

People today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching Wheel of Fortune are over for most people.

To serve retired clients properly, there are some key themes that advisers need to be aware of:

  • People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.
  • People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.
  • In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.
  • The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.

In this article, we are exploring a bias that affects investments in the retirement planning process: hindsight bias. In simple terms, hindsight bias is the impulse that insists: "I knew it all along!" This is perhaps the most pronounced version of the belief-perseverance biases. After an event has taken place, people afflicted with hindsight bias tend to perceive that the event was predictable--even if it wasn't.

This behaviour is precipitated by the fact that actual outcomes are more readily grasped by people's minds than the infinite array of outcomes that could have, but didn't, materialize.

Therefore, people tend to overestimate the accuracy of their own predictions. This view is often caused by the reconstructive nature of memory. When people look back, they do not have perfect memory. Instead, they tend to "fill in the gaps" with what they prefer to believe. In doing so, people may prevent themselves from learning from the past.

Investment implications for retirement planning

One of the most obvious examples of hindsight bias in recent history was the prevailing response by investors to the behaviour of the U.S. stock market between 1995 and 2002. The stock market rallied by a significant amount during the Internet stock boom, and then--which seems obvious in retrospect--the stock market collapsed in March 2000. Many people, in hindsight, saw this as predictable, but very few actually avoided losses during this period.

Let's consider a specific investment example in the retirement context. Hindsight-biased investors can unduly fault their money managers when funds perform poorly. Looking back at what has occurred in securities markets over a 5- or 10-year period, these investors perceive every development as inevitable.

Today, in 2016, U.S. government bond rates serve as a prime example. They seem ultra-low by historical standards. Will they revert to normal levels? Investors have thought so for years, but it has not happened. Meanwhile, investors haven't really exited bonds. But when they do, people will likely say it was inevitable.

Furthermore, it is very unlikely that many investors will avoid losses associated with the looming U.S. interest rate hike. Retirees, many of whom have healthy fixed-income allocations, will be affected by this phenomenon, and advisers need to be ready to react when this happens.

Dealing with hindsight bias

Hindsight bias is a difficult bias to measure, because people are rarely aware that they harbor it. Few are likely to take a test and effectively respond: "Yes, I am susceptible to 'I-knew-it-all-along' behaviour."

In order to overcome hindsight bias, it is necessary, as with most biases, for investors to understand and admit their susceptibility. Advisers should get their clients to understand that they are vulnerable to this bias and counsel their clients to address specific related problems that could arise.

Here is an approach that can help better deal with retirees who exhibit hindsight bias:

When a client overestimates the degree to which some investment outcome was foreseeable, and you suspect this is due to hindsight bias, gently point to the facts. Storytelling is a strategy that can help you communicate your point without offending your client. You might make reference, for example, to the collapse of the U.S. credit bubble in the 2008-09 period, when risks fueled by excessive credit cost stockholders billions. In the face of rationale like, "I knew that stock was going to go up! I told you so," a cautionary tale can highlight the pitfalls of overestimating one's own predictive powers.

Similarly, advisers need to recognise that many people prefer to block recollections of poor investment decisions. Understanding why investments go awry, however, is critical to obtaining insight into markets and, ultimately, to finding investment success. Counsel your clients to carefully examine their investment decisions, both good and bad. Such self-examination can help eliminate repeats of past investment mistakes.

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