Investors should learn to cope with uncertainty instead of trying to predict the future
Posted by: Uma Shashikant on Apr 24, 2017, 06.30 AM IST
By Uma Shashikant
To believe that we knew what was coming is a smug and satisfying feeling. Once something has happened, it is easy to explain why it was so predictable by simply collecting information from the past and fitting it into the present events. Psychologists call this the hindsight bias.
After every election, even if the results are completely different from what the opinion and exit polls and the pundits predicted, a lot of time is spent on the analysis of how the result was so obviously out there, waiting to happen, and how many markers in the past pointed to the very result. This classic game of hindsight bias plays out every time there is an unexpected turn of events.
In the complex environment of uncertainty, hindsight bias gives us the comfort and presents the possibility that we are still in control of things. We pride ourselves for knowing that something was bound to happen. Hindsight bias can lull us into believing that we can predict the course of future events. That is the danger of selectively picking data from the past to interpret an outcome.
Books about the most successful companies, or the best performing CEOs, or the patterns inherent in equity market crashes feed on hindsight bias. It is now known that many firms that were crowned as pillars of excellence, or moved from being good to becoming great, have shut down in failure and bankruptcy. The painstaking research into these success stories simply picked up from the past, information that confirmed and collaborated the present successes of the business, and was therefore a project in hindsight bias. There is nothing precious to learn from these selective instances, especially if one must make decisions for the future. Investors fall into the trap of hindsight bias very easily.
While there is enough data to show that many IPOs list at a discount, or lose more than 90% of their issue price within a year of listing, the popular view is that IPOs are easy money. When the buzz about the new issue is high, it is easy for people to point out how they knew it all. Congratulatory stories on listings are always about those sterling qualities that everyone seems to have identified and known all along—that this business would make it big.
However, such analysis is not helpful to the investor who must make a choice about the next IPO that is being sold in the market. They instead help a lot of poor quality IPOs to ride this bias and sell their equity to gullible investors. There have been enough businesses that have failed despite having a star CEO at the top. The factors that lead to the success of a business are so complex, that it is not possible to arrive at a formula that mixes up a few things—good manager, great product, expanding markets and such—and arrive at a surefire winner. Equity investing is about making a choice based on a current set of ideas, and monitoring closely how that story unveils over time.
To be able to observe and act in an unbiased manner, it is important to knock off the simplistic ideas about how it is easy to see it all coming together. It is not. The biggest limitation that hindsight bias brings about is the false sense of control and the easy interpretation of the outcome For every confirmatory story about what worked, the opposite can be shown to be true. Every industry holds leaders and laggards, and every business has its ups and downs.
The essential unpredictability of the future plays out as stock prices are available every day as an output of the actions of many people, who decide to buy or sell based on their need and view. This availability of this continuous stream of prices also triggers an analysis of patterns and formations. Technical analysis has devoted followers who see trends that are representative of how people behaved. That is the limited, but useful, role of technical analysis. It is a nice story of how demand and supply operated in the market place, and how much buyers were willing to pay, or how low prices fell before most gave up selling. But to imagine that this analysis would enable predicting how the future prices will play out, is a classic case of hindsight bias, and is doomed to mostly fail.
The essential unpredictability of stock prices is not altered by the tools of technical analysis. What instead is valuable is the unbiased observation of how prices behaved, and the ability to recognize these factors at play when one trades or invests in the market place. Successful trades have rule-based algorithms that make them money. But they will invariably meet the unexpected, and will find their algorithm failing. How they behave when this happens determines their success.
Naïve and new traders would suffer hindsight bias and expect the markets to move as their models predicted; smart and experienced traders will quickly spot that the market is playing a new uncharted game and will close their positions even if at a loss, and go back to their boards to rework. Hindsight bias also holds the danger of simplistic generalisations. If it were so easy to invest in “blue-chips” and simply sit back and make money, how is it that the blue chips of yesterday are the underperformers of today? The notion that banks will not be allowed to fail, drives the phases of buying into these stocks, without factoring in the deterioration in their balance sheets.
There is something new that is happening with the credits and advances of the banking industry- public and private-that investors should shake off their biases and be willing to look into. To think that we know what would happen, or we were able to tell that something would happen, or to hold that what happened was inevitable, are all degrees of hindsight bias that harm us as investors. These stances make someone sound like an expert, or create a false sense of control. The joy and challenge of investing comes from the ability to continuously learn from the unpredictable turn of events. Even these learners can have their moments of triumph and disaster. That is why the same stocks, the same funds, the same businesses, or the same nations do not remain at the top. That position revolves among players in a gloriously unpredictable manner.
(The author is Chairperson, Centre for Investment Education and Learning) This article appeared in Economic Times dated Apr 24, 2017, 06.30 AM IST