Chapter 11

Reconstruction (hindsight)

Who among us has never struggled to solve one of life’s little puzzles? Like working out how to fix something when the method was not clear and the parts we needed were apparently not available. After many false starts and experiments we find a solution. Feeling pleased with ourselves, we describe the problem and our thinking process to our friend Neil, who says nothing until we finish our long and detailed explanation. When we announce our solution, Neil says, ‘That is obvious! I could have told you that’.

It is entirely possible that Neil did indeed really know the answer to our problem before we started talking, but it is more likely that he gradually came to a realisation of the solution as we recounted our story, and by the time we had finished he really believed that he knew the answer to the problem all along. It would be harsh to dismiss his response as dishonest because we are all prone to this cognitive bias, whether we realise it or not.

If, instead of relating to Neil our process for solving the problem, we had described the problem to him first and asked how he might solve it, it is likely that Neil would have been as puzzled as we were at that stage. However, once we told him everything we found out, Neil naturally imagined that he had known some of those things beforehand and therefore it was not such a tough puzzle after all.

Recently Lucy has been telling anyone who will listen about a big win she had on the stock market. She bought a biotech stock that had raised capital to try to develop a new treatment for arthritis. Lucy has been regaling her listeners with lots of detail about how she knew the company had discovered a new compound that was central to the treatment, had taken out a patent on it and had completed clinical trials that had proved its effectiveness over existing treatments. As Lucy recounted her story, I was struck by the detail she had in her mind, the clarity of her reasoning and how her judgement had been perfect all along the way.

Of course, arthritis is a common health problem and there is a great demand for treatments that improve on what is available. A new and better treatment was bound to get a lot of media attention. As is often the case, the media told the story from a human interest angle. It gave great coverage to the chemist who led the research. Her story related how her team had started out trying to develop a totally different treatment, which had failed. Then, by a lucky coincidence, they tested the compound for treating arthritis and it performed wonderfully well.

Then one day I found out quite by accident that Lucy had bought eight biotech stocks at the time she bought the one that discovered the arthritis treatment. The other seven had mostly spent all the seed capital they raised without discovering anything and were almost worthless. Therefore, Lucy’s great stock market killing had mostly been good fortune.

Lucy was telling everyone what she knew and her story was reasonably accurate. However, she was claiming to have known things before they happened or before they were discovered, proven and made public. Before we think harshly of Lucy, if we think about it, we have all seen people do this many times in our lives. Only the situation and the details are different.

What happens is that these stories unfold over time. Afterwards, we have great difficulty remembering what we knew at the start and what we learned later and now believe we knew all along. In other words, we have the greatest difficulty placing in time when we knew what. The result is that we naturally tend to overestimate what we knew beforehand. It is not that Lucy was telling lies. What happened was that her mind had reconstructed the sequence of events so that she thought she knew things earlier than she did.

What Neil’s and Lucy’s stories illustrate is a very common cognitive bias called hindsight bias. Nobody is immune to it. Hindsight bias is far easier to see in others than in ourselves. It is a very difficult cognitive bias to overcome. The huge problem is that hindsight bias makes it very difficult for us to learn from experience, because our minds reconstruct what we knew when we made decisions.

Investing involves making decisions, the outcome of which is uncertain and the result of which we will not know until later. This makes investing very fertile ground for hindsight bias. When an investment works out well, and possibly even better than we expected, we tend to think we were smarter than we were. We are at great risk of taking credit for what may really have been nothing more than good fortune, as Lucy did.

The result is that we have an unrealistic opinion of our investing prowess. In particular, we tend to believe that we knew more than we did when we made the investing decision. This means we have a strong tendency to think we are smarter than we are. This gets in the way of our learning from experience and it can easily set us up for further failures.

Hindsight bias also arises out of another tendency we have: selective memory. In investing, we like to remember the profits, which were pleasant memories, but we suppress memory of the losses, which caused us feelings of pain. When we describe our investment exploits to others we focus on those investments that worked out well and which cast us and our investing ability in a good light.

We have all listened as our friends relate their investment ‘war stories’. Most of us have probably also told our own war stories. War stories are those exciting accounts we reconstruct verbally from memory of when an investment worked out brilliantly. Everyone loves telling war stories because they present us as brilliant investors with superior skills. What we need to be very aware of is that, while these war stories are great entertainment and make us feel good about ourselves, they are particularly unhelpful as a way of learning to be a better investor. This is because we are most unlikely to dwell on our poor investment judgements. If we mention them at all, it is to bemoan our loss was the result of bad luck, implying that it was really not our fault.

Because of our selective memory, we all tend to:

• reinforce the memory of our investment successes. We tend to take credit for what was just good fortune.

• suppress the memory of our investment failures. If we do recall them we dismiss them as bad luck rather than bad decisions by us.

The result is that we have a distorted memory of the number of wins relative to losses. At the same time, we have avoided taking responsibility for poor judgements. This magnifies our estimation of our investment prowess and promotes overconfidence in our decision-making ability. Our unbalanced memory of our success rate can cause us to take more risk than is warranted by our true investment record because we overestimate the probability of future success and underestimate the probability of future losses.

Selective memory is compounded by the tendency, explained earlier, for us to be unable to reconstruct exactly what we knew at the time we made an investment, as apart from what we found out afterwards. We tend to assume we knew things that in fact we could not have known at the time we made the decision.

These two tendencies, selective memory and faulty reconstruction of what we knew at the time rather than learned later, are lethal for our ability to learn from our experience.

Summary

Hindsight bias affects us in two main ways. First, we reconstruct history by mistaking when we knew things. We believe that we knew them earlier, when we actually learned them later. This leads us to think we were smarter in our decision making than we actually were. Second, our memory is selective because it magnifies our recollection of good decisions and suppresses our recollection of poor decisions. This leads us to think we are better decision makers than we are, so we become overconfident and take more risk than is warranted by our real ability.

Hindsight bias is easier to see in others than in ourselves. Even when we recognise it in others, it is still very difficult to deal with in ourselves because our reconstruction of history and selective memory are largely unconscious.

Strategies

1 It is essential to keep good records of our investing. All the great investors know that good records are essential and they put a lot of effort into record keeping. At any time our records should tell us what our return is for the year to date and for past years. Beyond that, we should summarise our investments in a way that gives our investment performance a good grounding in reality. Keeping a tally of the number of profitable and unprofitable investments is important. However, far more valuable will be also to know the total profit from the successful investments and the total loss from the unsuccessful investments. This is because it is a basic rule in investing to let profits build in successful investments, but to quickly close out the investments that do not work out. Therefore, it is likely that there will be more losing investments than winning ones, but the gains made in the smaller number of winners should greatly outweigh the total loss from the ones that did not work out and were quickly sold.

2 I keep an investment journal or diary for every investment I make. I start it before I buy a stock and write down what I knew when I made the decision and what my reasoning was. It must be done at the time, because trying to do it later leaves us open to hindsight bias. Our memory will have been reconstructed unconsciously, so we cannot be sure what we really knew and did not know at the time. Then, as we manage the investment, we record at the time all the decisions we make and what we knew when we made them.

When we have closed out an investment, we need to assess it. Do it in writing. Resist the urge to think that we knew anything that is not in our investment journal. Providing we are honest with ourselves, this is the most powerful investment learning tool I know. It counters hindsight bias because it enables us to recreate what we knew and thought when we made the decision. Then we will be on the way to defeating hindsight bias.