Hindsight, they say, is a wonderful thing. Understanding a situation and the events that led up to it can help you make better decisions in the future. It’s always good to learn from the past, especially when investing, but hindsight bias could be doing more harm than good when it comes to your investments.
When you look back at certain points in your life, there are probably situations you would like to go back and react differently to, given half the chance.
Return to that point in time, and you might say yes to that risky job opportunity, put an offer down on your dream house more quickly, or hold onto your investments through short-term volatility.
Whilst it’s good to look back at a situation and the sequence of events that led up to it, it can be easy to assume an outcome was more predictable than it actually was.
This is known as hindsight bias, and is a behavioural phenomenon that’s particularly pertinent in the investing world.
Hindsight bias can lead to incorrect analysis of situations, and can influence behaviour in a way that can hurt investor returns in the future through overconfidence.
Hindsight bias when investing
When you invest, you want to buy an asset at a low price and sell it for a higher one. You pocket the difference as a profit, once you’ve taken out the impact of inflation and cost of trading.
When you’re managing your money for the future, you’re under pressure to spot market trends and react to them in the right way. Failing to recognise or understand market trends early enough can lead to regret, which could magnify behaviour later down the line.
Hindsight bias and the financial crisis
After the 2008 global financial crisis, for example, analysts and commentators poured over the small events, repackaging them as the obvious signposts directing investors along the road towards financial strain.
The truth is, however, if these signs were really so obvious, a financial crisis could probably have been avoided.
Hindsight is especially popular after periods of financial strain or crises. The perceived understanding hindsight brings can be more comforting in periods of uncertainty that admitting you don’t know what’s going on.
What’s wrong with hindsight?
It’s not the concept of analysis and review that makes hindsight bias a dangerous habit to form, it’s the overconfidence it brings. Overconfidence can impact your ability to make objective valuations, especially if you think you’re gifted with the ability to predict the future.
Before you start investing, it’s important you build an investment strategy that’s designed to help you reach your goals.
It’s this strategy that removes the personal hunches and gambling aspect of investing, and helps you make the right investment decisions.
Valuing an investment
To ensure your investment strategy is stringent enough to manage risk properly, you will need to:
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- Develop long-term forecasts for the economy and financial markets to outline the strategic asset allocation of your portfolio
- Optimise this asset allocation to build a portfolio designed to reflect your investor profile, tolerance for risk and time horizon
- Enhance the risk/return profile of your portfolio with a tactical overlay as part of the rebalancing process
It can be easy to get carried away with a gut feeling, but instead investment decisions should be made on data to ensure they are as reliable as possible. Analysts have stringent due diligence processes to value investments and markets and forecast returns.
Here, we outline common investment calculations used by analysts for to build financial market forecasts for equities and bond markets.
Professor Shiller’s Cyclically Adjusted Price Earnings model (PE) is a traditional valuation model that looks at an asset’s price compared to its earnings.
The simple calculation goes like this: Price/Earnings = PE
It reflects what the company is worth in regards to its earnings. There’s no one size fits all guide to the PE ratio, and different sectors have different averages.
Typically, it’s seen that a lower PE indicates an investment is valued cheaply, whilst a higher PE looks expensive. Whether the asset valuations are supported is another question.
To estimate the returns on a debt security, many investors use the yield to maturity. This yield to maturity calculates the total expected return, including coupon payments and the final repayment of the principal, assuming it’s held to the end of its life.
Essentially, it’s the bonds internal rate of return.
Once you have outlined the expected returns for each asset class, it’s important to translate this information into allocation of assets in your portfolio to ensure your portfolio it built in the best way for you.
There are a number of complex calculations that go into this optimisation process, which needs to be robust to ensure you have exposure to the maximum possible return for a given level of risk.
Keeping the emotions out of investing
Reflection can help improve your investment habits, but it’s important you keep the emotions out of investing if you want to build the portfolio that’s going to help you reach your goals. Unfortunately, it can be rather difficult to achieve.
Here are four tips to cultivate your successful investing habits:
- Let an expert manage your money
If you don’t have the time to properly manage your investments yourself, get an expert to do it for you. Thanks to low-cost digital wealth managers like Moneyfarm, this doesn’t need to be expensive.
- Invest regularly
Instead of trying to time the market and regretting missed opportunities, set up direct debits to benefit from pound cost averaging and maximise your returns.
Diversify your investments across asset classes and geographies, so you’re not reliant on one asset to do well.
- Invest for the long term.
It’s well known that it’s ‘time in’ not ‘timing’ the market that can help maximise your returns over the long-term, helping you avoid knee-jerk reactions and allowing you to benefit from long-term growth trends.