When Hindsight Isn't 20/20

This month's article is the sixth in a series called "Managing Behavior in a Volatile Market" and Part I of a very important bias, hindsight. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies just hit the cyber-market.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with hindsight bias. Fifty percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to hindsight bias (i.e., when reflecting on past investment mistakes, they believe that many could have been easily avoided). Of that group, at least half were also subject to the following six biases:

1. Regret (68%)
2. Loss Aversion (66%)
3. Anchoring (62%)
4. Status Quo (58%)
5. Representativeness (58%)
6. Outcome (50%)

For example, of the respondents who said they were subject to hindsight bias, 68% of them were also subject to a question designed to identify regret bias, and so on for the other five biases.

In this article, I will provide commentary on the first three of these biases: regret, loss aversion, and anchoring. I will discuss why these biases are likely linked with hindsight and what you can do to counsel a client with these biases.

Hindsight and Regret
Hindsight and regret are connected; this may need some explanation, however.  Hindsight bias occurs when people reflect on past investment mistakes and believe that many could have been easily avoided. In fact, many top investors make mistakes all the time. We want to think we are smart and can avoid these errors, but this bias perpetuates that myth.

In a similar but not-exactly-identical vein, regret-aversion bias occurs when people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Here again, people want to think they are smart and may tend to avoid making decisions for fear they might make the wrong decision. For example, regret aversion can keep some investors out of a market that has recently generated sharp losses. Having experienced losses, our instincts tell us that to continue investing is not prudent. Yet periods of depressed prices may present great buying opportunities.

Advice: My advice to those investors subject to regret bias is to accept the fact that investment mistakes will occur. The important part is that a structured process is followed and discipline is actively pursued. 

Hindsight and Loss Aversion
Hindsight bias and loss aversion bias appear naturally tied; let's dig into the details. When people are subject to loss aversion, they often don't like to admit they were wrong by taking a loss. Similar to regret-aversion bias and hindsight, people want to think they are smart and don't want to admit that they made a bad decision. For example, if Paul buys a stock fund at $120 and it goes down to $80, loss aversion may lead Paul to hold this loser even if the investment has little or no chance of going back up anytime soon. Similarly, loss-aversion bias can lead to risk avoidance when people evaluate a potential gain. Given the possibility of giving back gains already realized, investors often lock in profits, thus limiting their upside.

Advice: Because loss aversion is an emotional response to losing money, it is often difficult to correct. I recommend that advisors focus their clients' attention not on the purchase price but rather the prospect of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action becomes clear.

Hindsight and Status Quo Bias
Hindsight and status quo are connected, although it may not be obvious why. Some investors are generally more emotionally comfortable keeping things the same than with making a change, and thus they do not necessarily look for opportunities where change is beneficial. Given no apparent problem requiring a decision, the status quo is maintained. Similar to regret and hindsight, people want to avoid looking unwise; in this case, they may not want to make a decision because they may make the wrong one.

Advice: Getting investors who do not wish to take action to "get off the dime" and make some decisions is not easy. And demonstrating through quantitative analysis is not always effective. What I often recommend in this case is to take action in smaller increments. For example, if the task is to get invested, then clients can "average in" to the markets--taking three months or six months to get invested.  This often puts the fear of losses aside; if an investment goes down you can buy more at lower prices. 

Conclusion
I hope you have learned something about hindsight and the biases connected with it. When you encounter a client with hindsight bias, think about the biases you have read about in this article. It might help to build a better client relationship! In next month's article, we will review the next three biases associated with hindsight.