Predicting the Past: How Investors Can Be Fooled by Hindsight Bias

In the 1980s classic film series Back to the Future, the villain of the franchise manages to travel back in time with a sports almanac and give the book to his younger self. Then, having unique knowledge about the future, he is able to predict an endless array of outcomes for major sporting events with perfect accuracy. Betting on those outcomes, he quickly becomes one of the wealthiest men. Of course, he knows that he’s cheating. But, to everyone else, Biff Tannen seems like the smartest person in the world.

Although none of us knows with absolute certainty what the future holds, there are plenty among us who are able to fool people into thinking that they can. Sometimes, we can even fool ourselves. After an event has occurred, we may tell ourselves, “I saw that coming,” even if we only realized after the fact how the events may have unfolded. Our minds just naturally gravitate toward an explanation, and we are really bad at realizing that there actually was no explanation until after the event had occurred. Psychologists refer to this as hindsight bias. After the mystery is solved, we suddenly see all the “clues.” And yet, if the mystery had been solved in another way, those very same “clues” would have been irrelevant details that we simply ignored.

Now, it’s one thing for us to fool ourselves into believing we have some kind of mystical predictive power. However, it’s another story to try to convince others that we have that intuition. Many people use their ability to explain the past as a means of exploiting people into believing they can predict the future. This sort of thing happens in all sorts of contexts, but perhaps one of the most insidious areas in which this trick is played is in the world of investing.

Financial advisors will prey on investors’ susceptibility to hindsight bias by attempting to convince them that knowledge of the market can be gleaned from the past performance of the market. But the truth is that the past will never be a perfect predictor of the future. You can’t measure a snake until it’s dead! Investors may go through the records and tally up the previous ten to fifteen years of a particular asset class. Then, if they determine that its performance has been poor, they might jump to the conclusion that it’s a lousy investment. But here’s the thing: the investment could easily swing in the other direction over the next ten to fifteen years. There is simply no way of telling, based on the past, what is going to happen in the future.

So, here’s our advice: don’t be fooled by the smooth talk of financial advisors…and don’t be fooled by your own mind! The financial gurus can’t predict the future, and you can’t predict the future either. No matter how well you understand the past, that doesn’t mean you can project that knowledge onto the future. Our minds are wired for pattern recognition; we’ve got to stay vigilant to make sure they don’t trick us. If you need help managing how to respond to trends in the marketplace in light of problems such as hindsight bias, feel free to reach out to us for a complimentary consultation. We want to help you be ready for the future, regardless of what has happened in the past.

Photo CC by Sam Greenhalgh