How to Fight Hindsight Bias

Stocks have never experienced this level of destruction in such a short amount of time.

The question on investor’s mind is, where do we go from here?

There are two scenarios that can play out. Of course there are a million derivations of each path, but broadly speaking this is what we can expect:

The situation worsens in terms of the virus spreading and its effect on the economy. This seems like fait accompli at this point, but maybe the market, even down 30%, still has not properly discounted what’s to come. We’ll look back in amazement at the levels of complacency and in some cases outright denial.

Or

The virus passes through our system quicker than expected, and the market has already discounted the worst case scenario. Stocks recover most or all of their losses over the next few months, quarters or possibly years. We’ll look back in amazement at the time when stocks fell 30% in a few weeks because of a temporary slowdown in the economy.

At this point, I wouldn’t be surprised if either scenario plays out. The problem is that whatever comes to pass will appear obvious after the fact.

“Well so what?” you might be wondering. Why is it a problem? Hindsight bias is a problem because it leads to overconfidence, which leads to more risk taking, which leads to bad decisions, which leads to lower returns.

The best way to protect yourself from distorting your past views that were wrong into predictions that were right is to write them down.

For example, this is where I stand at the moment.

I’D place the odds of the economy heading into a recession at better than 90%. I’m very worried for people who are going to face extraordinarily hard times over the coming months.

As far as the markets go, I don’t think the S&P 500 low of 2367.04 is going to hold. I’d put the odds of new lows at 60%. My best guess is we get a ~10% rally and roll over, ultimately falling 40% from peak-to-trough. I don’t believe this with very much conviction, let’s go with 10%, and I do not plan on acting on my intuition.

Is this a cop out? Yes. Will it remind me in the future that, no, you didn’t see this coming. YES!

So here is what I plan on doing.

I will continue to make regular automatic contributions into my 401(k) and into my taxable account. Both are fully invested in the stock market.  If stocks fall 40% from their peak, so another 18% from here, then I plan on taking money out of my emergency reserve and moving it into the market. If they fall 50%, or another 17% from where I bought, then I will buy more. If they keep falling, then I’ll have bigger things to worry about than my portfolio.

I encourage you to write down your thoughts and put together some sort of plan if you haven’t already.

If you’re on the brink right now, imagine how you’ll feel if stocks fall another 20%. I hope we never get there, but investors have to be prepared for anything at this point, because right now, nothing feels obvious, and hindsight is 2020.

 

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.