Hindsight Thinking

Hindsight Thinking

May 05, 2021

Have you ever thought to yourself “I knew that was going to happen” when it comes to your investments? Thinking that you should have invested at that exact moment in that one fund because you knew it was going to skyrocket and could’ve “made a killing”. Many people do and it is in our human nature to think and feel this way.

This feeling is what behavioral financial professionals call Hindsight Bias. It can be explained as a psychological phenomenon that allows individuals to convince themselves after an event that they had accurately predicted it before it happened. Which can lead people to conclude that they can accurately predict other events before they happen.

As it pertains to investing, we see it time and time again with the average investor. They likely hear about an investment (ETF, Mutual Fund, stock, etc…), at work or some social media outlet. And for whatever reason, let’s say they got too busy, they do not invest. And what happens? The investment might shoot up in price. Then, due to hindsight bias, they think to themselves that they knew the investment was going to go up and start to get a false sense of confidence.

As always, they hear about a new investment from a similar place. This time they purchase it right away thinking it must go up because they “predicted” an increase with the last investment and don’t want to miss out. Unfortunately, most of the time it does not, and they likely sell it at a loss to get into the next new investment. Then the vicious cycle continues, possibly having significant negative effects on your long-term financial plan. 

So how do you stop yourself from thinking and acting this way when it comes to your investments?

Implement an investment plan and stick to it (easier said than done).

Historically, and as DALBAR has shown us for the past 27 years, the best investment plan for the average investor is generally a buy and hold strategy.

Now, you may be asking yourself - who is DALBAR and how do you define the average investor?

They are one of the financial community’s leading independent experts for evaluating, auditing, and rating business practices, customer performance, product quality and service since 1976.  And the average investor refers to the world of all mutual fund investors whose actions and financial results are restated to represent a single investor. This allows the entire universe of mutual fund investors to be used as the statistical sample, ensuring ultimate reliability.

For the year 2020, which showed a significant drop in the equity markets followed by a swift recovery, it was shown that the buy and hold strategy was the better choice when compared to the average investor (as shown in the table below).

This table compares two hypothetical investors. The first hypothetical investor starts with a $100,000 investment, but cash flows mimic proportionally that of the Average Equity Fund Investor. The second hypothetical investor has a $100,000 equity portfolio that is held throughout the year of 2020. The table compares the money earned for the end of each quarter in 2020.

Source: DALBAR 2021 Quantitative Analysis of Investor Behavior Report

As you can see, the holders earned extra over the average investors in every quarter in 2020. The reason being that the average investor withdrew money from their equities and did so at a faster rate as the market started to make its recovery (which no one knew if/when it would happen). Meaning that the average investor missed out on gains from not being in the market. Although over one year it can seem insignificant, but over the long-term (due to compounding of earnings) can have a substantial impact on your financial plan. 

Creating, implementing, and being able to stick to an investment plan can help eliminate the mistakes you may make when reacting due to hindsight bias. This, in my opinion, is easier to do with the help of an outside resource (preferably a financial planning professional). Someone who can see things through a different light and can help you from being overconfident and stop yourself from constantly thinking “I knew that was going to happen.” 

The information is illustrative only and provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance shown is not indicative of future results, which could differ substantially.

The hypothetical back tested data shown is not indicative of future results, which could differ substantially. It does not reflect actual account performance for any specific client or a composite performance for a group of clients. The hypothetical back tested data shown were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight, were compiled after the end of the period depicted, and do not represent the actual investment decisions of the Advisor. This does not reflect the impact that material economic and market factors may have had on decision making.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

DALBAR, Inc. is the financial community’s leading independent expert for evaluating, auditing and rating business practices, customer performance, product quality and service. Launched in 1976, DALBAR has earned the recognition for consistent and unbiased evaluations of investment companies, registered investment advisers, insurance companies, broker/dealers, retirement plan providers and financial professionals. www.dalbar.com Report source- Quantitative Analysis of Investor Behavior. 2021

Melone Private Wealth, LLC (“Melone Private Wealth”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Melone Private Wealth and its representatives are properly licensed or exempt from licensure.

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