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Looking Past Hindsight Bias

Clients who are susceptible to hindsight bias may also have secondary behavioral tendencies, including status quo, representativeness, and regret bias.

Michael M. Pompian, 04/19/2012

This month's article is the seventh in a series called "Managing Behavior in a Volatile Market" and Part II 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 second three of these biases: status quo, representativeness, and outcome. I will discuss why these biases are likely linked with hindsight and what you can do to counsel a client who has these biases.

Hindsight and Status Quo
Hindsight and status quo are connected, although it may not be obvious why. Some investors are more emotionally comfortable keeping things the same than with making changes, and thus they don't 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 whenever possible; in this case, they may not want to make a decision, because they may make the wrong one.

Advice: When clients are reluctant to take action, getting them "off the dime" to make 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.

Hindsight and Representativeness
Hindsight bias and representativeness may not appear naturally tied; let's dig into the details. Clients subject to representativeness bias use prior experiences as a frame of reference for current decisions. (Technically speaking, representativeness bias is a belief-perseverance bias in which people, when confronted with new information, use pre-existing beliefs to help classify the information even if the new information does not necessarily fit an existing belief.) Hindsight bias is the belief that investment outcomes should have been able to be predicted. Putting these two ideas together, clients often have their own views or reference points from which they judge current investment decisions--and these views can potentially be biased. When this happens, they may disregard important considerations such as the prospects for the investment or valuation that may be key drivers of future investment success.

Advice: As I have noted in past articles, advisors need to encourage their clients to judge every investment idea on its current merits, not based on past experiences. It's not always easy! Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking, and most importantly, pay attention to valuation.

Hindsight and Outcome
Hindsight and outcome bias are certainly connected. In the context of investments, outcome bias refers to the tendency of individuals to make investment decisions--such as making an investment in a mutual fund--based on the outcome of past events (such as returns of the past five years) rather than by observing the process through which the outcome came about (i.e., the investment process used by the mutual fund manager over the past five years). An investor might think: "This manager had a fantastic five years, I am going to invest with her" rather than understanding how such great returns were generated or why the returns generated by other managers might not have had good results over the past five years. As it relates to hindsight, clients who believe that investment outcomes should be predictable may indeed be attracted to managers who have recently performed well.

Advice: The natural advice for those subject to outcome bias is to focus not so much on the outcome of an investment opportunity but the process by which the investment decision is being made. If one makes money but did so in a way that did not follow a structured process, then this is luck. Conversely, if one does not make money but had a sound reason for making the investment--even though circumstances went against the investment--then this is likely a better investing process that may be counted upon to be reliable in the future.

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! Next month's article will review biases associated with recency bias.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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