“We have met the enemy and he is us.”
—Pogo (via cartoonist Walt Kelly)
Famous investor John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
Given Templeton’s indisputable success as an investor, few would argue with this appeal. However, like much in life, this behavior discipline is easier said than done. Research shows that people tend to make rational decisions in small matters and poor ones where much is at stake. Why? Because we’re human. As humans, we are burdened with a series of nearly inescapable cognitive and emotional biases that drive us to respond to stressful events like the stock market’s ups and downs in a way that harms our financial well-being. While numerous, this article will work to consider just one: Hindsight Bias.
Hindsight tricks us into believing we would have avoided the mistakes made by others, and assists us in forgetting mistakes we’ve already made. It’s the everyone-else- is-an- idiot-but- I’m-completely- rational syndrome. The problem with this bias is that while understanding history is an important part of becoming a successful investor, it’s not enough because hindsight is a benefit that makes the past look too easy. Worse yet, history is no help if it leads to overconfidence in our ability to predict the future.
The stock market presents prospective losers the alluring temptation to convince ourselves that we could have made the right choice had we tried harder, or that we will certainly be able to do so in the future. An appropriate metaphor is the widespread activity of Monday morning quarterbacking: We believe by Monday (with the unacknowledged benefit of hindsight) that we would have been better able than our team to identify the strategy that would have won the game.
To confirm the pervasiveness of Monday morning quarterbacking in the stock market, I suspect many of us have heard our friends, family and co-workers utter the following:
Of course, I knew that it was time to get out of tech stocks before the Internet bubble burst in 2000.
Of course, I knew that the levering up of real estate was a bad idea in 2007.
Of course, I knew that it was time to buy stocks at the bottom in March of 2009.
Of course, I knew that the political surprises in Great Britain (Brexit) and the U.S. (2016 Presidential election results) would be mere blips on the upward trajectory of US stocks.
Of course, I knew the stock market would surrender nearly 10% over two hectic weeks in early 2018.
Of course you knew. But you didn’t.
Everyone is rational, logical, and disciplined when looking at the past. But when we’re in the moment, and the stakes are high, psychological stress impairs cognitive skill and warps decision making. Instinct expressed through emotion distorts our ability to reason and pushes us to join the panicking herd which temporarily reduces our anxiety…but also our wealth.
The solution? An honest, objective appraisal of our appetite and tolerance for risk before it strikes. We need the right blend of stocks and bonds that will allow us to stick with our financial plan and even rebalance into the pain. We need to make sure we have surplus cash separate from our investment portfolio to provide us with the fortitude to survive a market downturn and avoid becoming a forced seller. In sum, we need self-restraint, savings, and the disciplined stoicism to see a plan through.
As Rudyard Kipling urged, "keep your head when all about you are losing theirs." And while not easy, successful investors will do it. And they’ll do it despite the foibles and flaws of the man in the mirror.
Kevin McVeigh, CFA is a Managing Director and Partner at Exchange Capital Management, a fee-only, fiduciary financial planning firm. The opinions expressed in this article are his own.