In last week’s column, I implored investors to ask why whenever they hear or read some sort of claim about an investment’s future prospects or even past performance.
Just because stocks have returned 11 percent over some past time period does not mean they will do so in the future, even in the long run. We need to piece together the conditions that existed at the beginning, middle and end of the time period we are examining. Only by understanding the facts and circumstance of earlier times can we know whether to expect similar results going forward.
Human beings are hard-wired to find patterns. We observe some phenomenon, and we instinctively piece together an explanation of why it happened that way. The problem is that we are prone to committing a host of errors in constructing our little personal theories.
The scientific method was developed over the last few centuries in direct response to these very human errors. The goal is to weed out all the mistakes in observation and interpretation that our brains try to impose on us.
So, even if investors take my advice and pause to ask why, they are prone to mistakes. Perhaps the most common of these mistakes are hindsight bias and comfirmation bias. Hindsight bias is the art of observing a current situation and then forming an explanation of why we see what we see.
The punch line is when we generalize that explanation to all sorts of situations to which it does not apply.
Here is an example of hindsight bias:
You’re sitting in the pews at a wedding, basking in the joy of the day. The bride is stunning, the groom is handsome. You talk with the person next to you who knows the bride and groom quite well, and she tells you that the groom is quiet and reserved and likes to read poetry. On the other hand, the bride is outgoing and boisterous and full of spunk.
You and your friend nod knowingly and say in unison, “Opposites attract.” You chat about how opposites really do make the best partners in a marriage.
A few weeks later, you’re at another wedding and your seatmate tells you about how the bride and groom met at a triathlon, had the same major in college and share a dream of teaching overseas. The two of you smile knowingly and say in unison, “Birds of a feather flock together.”
So, which is it? In each of these cases, the observer used a selective memory to explain what they saw in front of them. Rather than consider all of the couples they have known, they rapidly recall only those that match the current situation and conclude that, gosh, this is how it works all the time.
We come up with so-called rules when, in fact, there are no such rules. People have tried to explain male-female relations since the dawn of humanity and, to my knowledge, we are no closer than ever to a unified theory.
Investors do the same thing. We are prone to forming expectations for our investments by looking selectively into the past. We recall only the past situations that agree with what we hope to see. If we already own, say, Treasury bonds, we will turn our eyes to past periods where such bonds have done quite well. Having bought a basket of stocks, we will comfort ourselves with a selective review of the past wherein stocks were the winning choice.
We recall the minority of past periods during which stocks have done well in a rising inflation environment, and use that biased result to justify the purchase of more stocks today.
We take small snapshots of the past and generalize them out into the future. But to do so is as foolish as trying to generalize the dynamics of one married couple out to all future potential couples.
Another example is the person that claimed to know if my wife was carrying a boy or a girl. She’s carrying it low or high or up or down or sideways. Each of these means it is definitely a boy ... or a girl. The baby forecaster truly believes she is always right because she only remembers when she is right, which is half the time.
Investment decision-making is fraught with uncertainty. I read daily shockingly bad explanations of what is going on in the world. Not bad in the sense that they are definitely wrong, but bad in the sense that the writer is clearly suffering from hindsight bias and is using a tiny sample of the past to generalize about the future.
You will do well to look for this bias in the investment advice you receive.