This week's Money Bias Series highlights two biases that tend to show up quite a lot in personal finance: hindsight bias and confirmation bias.

Hindsight bias is present when looking back at previous market bubbles — Tulip Mania (check), the dot-com bubble (check) and the Great Recession (check). Looking at past indicators, most investors would assume that the events were predictable, however if that was truly the case then one can argue that the downturn should have been prevented. Hindsight bias can influence our present day decisions, so we must recognize it before acting.

Confirmation bias, well, I’ll just say this… CNN or Fox News?

Read our blog to better understand how you can identify hindsight bias and confirmation bias before they influence your financial decisions.

What is hindsight bias?

Hindsight bias is the tendency people have to perceive that previous events were more predictable than they truly were.

An example of hindsight bias can be found after the dot-com bubble of the early 2000s.  The dot-com bubble lasted from 2000 to 2002.  Many of the “.com” companies were not profitable, and yet were able to capture investment from the average household investor to large venture capitalists.  Internet companies were taking off.   According to the Wall Street Journal, at the peak of the dot-com bubble the NASDAQ had a P/E Ratio (price to earnings ratio) of over 100 compared to the broad stock market index of 20.

I just dropped a few acronyms in the last sentence, and for that I apologize.  If you haven’t already, check out our Acronyms Seriously Suck Especially in Finance blog to understand NASDAQ and P/E Ratio.

A P/E Ratio that high means the NASDAQ was extremely overvalued.  We know this now, but at the time, everyone had a valid explanation for it.  As we all know, the bubble popped, and by the end of 2002 the NASDAQ lost 78% of its value.  That equated to $5 trillion in market capitalization.  It’s way too easy to look at that moment in history and say, ‘What fools! I would have never fallen for that!’  Those thoughts lead to hindsight bias.

Hindsight bias tends to show up after any market bubble.  It’s been around since Tulip Mania and the Great Recession.  Looking back, investors and talking pundits on television can say that the indicators were there to see the market decline coming.  If that is truly the case, then the market decline itself would have been prevented.

What can hindsight bias lead to?

Hindsight bias can lead to overconfidence (Natalie described this in the first part of our series) in your ability as an investor to select stocks.  Hindsight bias like many other biases can lead to a tendency of market timing.  Market timing is an extremely dangerous activity for investors.  According to a study done by JPMorgan, if you missed only the 10 best days of the S&P 500 between 2000 and 2019 your investment return would have decreased by 50% compared to staying invested the entire time.  Market timers have an increased probability of missing those 10 best days.

How do you recognize hindsight bias?

It’s important to ask yourself the following questions:

• What do I know now that I didn’t know then?
• What events in the past are giving me belief/disbelief in this decision?
• Is this decision being made with my long term or short term outlook in mind?

As we say, hindsight is 20/20 -- no, not the year 2020, although the year provided us with numerous events to say “I told you so”.  I encourage you to break away from hindsight bias when looking back.

What is confirmation bias?

Confirmation bias is the tendency to interpret new evidence as confirmation of one’s existing belief.

Here are a few examples of confirmation bias:

• Selecting to change your future 401(k) contributions to all cash because you have a belief that the market is going to lose everything.  This belief of yours has been confirmed by your favorite late night television infomercial stating that the end is near, matching to what you’ve thought this whole time.
• Do you remember the 2012 Mayan apocalypse?
• You invest in a specific company only looking for confirming evidence rather than disconfirming evidence to support your decision framework.
• Personal example: When we lived in Portland, OR the products of Beyond Meat and Impossible Foods were everywhere creating a narrative in my mind this is the way of the future.  This coupled with a Beyond Meat IPO tempted me to invest in the company, but I decided not to.  Since being back in Minnesota, I’ve come to the realization that plant based meat doesn’t exist in the Midwest nearly to the scale of the West Coast.
• I saved the best for last and will not elaborate any further...
• CNN or Fox News?

What can confirmation bias lead to?

Confirmation bias can lead to a single stock allocation.  This can cause your entire portfolio to be overweight in one company.  This includes those of you who are overweight in your employer’s stock.  We advise clients to have no more than 5% - 10% of their net worth in one company.  Confirmation bias can also lead to missing out on market upswings.  It’s worth repeating -- market timing is dangerous.  Confirmation bias can also lead you to a position of assumptions when talking or thinking about a person with differing worldviews.

How do you recognize confirmation bias?

It’s important to ask yourself the following questions:

• Am I only listening to opinions that match my own?
• How are my confirmations impacting my long term financial plan?
• Are you truly LISTENING to other disconfirming opinions?

The first step to being a better financial steward is acknowledging that biases do exist within your decision making.  A few ways to help with this is by journaling your thoughts regarding your financial decisions, setting intentions prior to making a decision, or working with a financial expert for accountability and collaboration (like us!).   

Coming up next: 

• The Narrative Fallacy & Representative Bias
• Framing Bias & Anchoring Bias
• Loss Aversion & Herding Mentality

Previous:

• Overconfidence & Self Attribution Bias

- Dan


Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.