How Hindsight Bias Hurts Investors

Shannon McCue |
Categories
Investments

How many of your financial choices are based purely on logic?

It could be fewer than you think.

That’s because most of us make money decisions with our emotions in play.1

With that, certain biases can follow. When they do, those biases can lead even the smartest, best-intentioned investors astray.

Here’s how to recognize three common biases - hindsight bias, fear of missing out (FOMO), and survivorship bias - and avoid their traps.

The Allure of High-Performing Stocks

Over the past two decades, companies like Amazon, Apple, and Tesla have become household names, largely due to their staggering market success. Investors who bought into these companies early and held on saw incredible returns. That can make it tempting to look at these success stories and think, if only I had invested back then…

This mindset is typically fueled by hindsight bias, a way of thinking that can mislead us into seeing past events as more predictable than they actually were at the time. With that, we tend to sideline or even forget the uncertainty, risks, and competing narratives that existed back when those decisions had to be made.

What Is Hindsight Bias?

Hindsight bias distorts how we view and interpret past events. It makes us believe we “knew it all along” when, in reality, we’re reconstructing history with the benefit of knowing outcomes we didn’t have before.

Example: In the early 2000s, Amazon’s future was far from certain. Its business model was questioned, and competitors loomed large. Many analysts doubted whether Amazon could sustain its growth. Now, after Amazon’s dominance has become clear, it’s easy to think, of course, it was a good investment!

Problem: Hindsight bias can lead to risky decisions, like chasing “the next Amazon” based solely on past performance, while overlooking uncertainties in new ventures.

How to Combat the Hindsight Bias: Instead of looking backward with regret, focus on forward-thinking strategies that prioritize long-term goals and diversification. Remember, even the best-performing companies today faced skepticism and risk as they got started.

Fear of Missing Out (FOMO)

FOMO is a powerful motivator. When headlines tout soaring returns from popular stocks, cryptocurrencies, or other assets, it’s natural to want a piece of the action. However, FOMO-driven investing often leads to impulsive decisions, like buying at market peaks or over-allocating to a single, overhyped sector.

Example: The Bitcoin craze is a prime instance of FOMO gone wild. Many investors jumped in during its meteoric rise in late 2017, only to see their investments lose significant value when the bubble burst.2

Problem: FOMO prioritizes short-term trends over long-term strategy. That can increase the likelihood of buying high and selling low while creating overexposure to riskier assets.

How to Combat FOMO: Counter FOMO by maintaining a disciplined investment approach. Identify your risk tolerance and keep your goals front and center, so you’re not constantly reacting to market noise and hype.

Survivorship Bias

Survivorship bias describes the tendency to focus on successful investments while overlooking those that failed. For every Amazon or Tesla, there are countless companies that never delivered on their promises—or that ended up failing altogether.

Example: Consider the dot-com bubble of the early 2000s. While Amazon survived and thrived, many other internet companies failed spectacularly. Yet, in hindsight, investors may only remember the winners, distorting their perception of risk and success.

Problem: Survivorship bias can lead to unrealistic expectations. It ignores the importance of diversification, assuming it’s “easy” to pick the winners while minimizing the risks involved.

How to Combat Survivorship Bias: Acknowledge that no one can consistently predict which companies will succeed. Diversify your portfolio to spread risk and avoid going “all in” on one investment, so you’re not solely relying on its success.

The Power of Long-Term, Diversified Investing

Cognitive biases like hindsight bias, FOMO, and survivorship bias can derail your financial plans. To counter that and stay on track to achieve big-picture goals, it’s generally better to prioritize:

  • Diversification: Spread your investments across different asset classes, industries, and geographies to mitigate risk.
  • Patience: Resist the urge to chase short-term returns. True wealth-building happens over decades, not days.
  • Your Goals: Align your investments with your values and personal financial objectives, not the latest market trends and fads.

With a disciplined, long-term investment strategy centered on diversification, patience, and your goals, you’ll be better equipped to mute cognitive biases before they have a chance to seriously disrupt your financial choices.

A Better Way to Combat Bias in Your Financial Life

The hindsight bias, FOMO, and survivorship bias aren’t the only biases that can interfere with prudent financial choices and better outcomes. Many others can also creep in, especially in the face of uncertainty. Keeping them in check and recognizing their influence can require an ongoing effort that you don’t have to handle alone.

Having a financial professional in your corner can help you balance emotions and offset any biases in your investing decisions, so you can make better choices that truly support your long-term objectives.

Sources:

  1. Psychology Today, 2024 [URL: https://www.psychologytoday.com/intl/blog/psychology-money-and-happiness/202403/how-emotions-impact-your-financial-decisions]
  2. CNN, 2024 [URL: https://www.cnn.com/2024/11/19/business/bitcoin-should-you-invest/index.html]

This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2024 Advisor Websites.