How many times have you heard someone say, “In 2008 I knew the market was going to crash…” – or some similar statement of prescience?

 

That would be an example of how hindsight creates an illusion of understanding, as described by psychologist Daniel Kahneman, who won a Nobel Prize in economics for his work in behavioral finance.  In his recent book Thinking, Fast and Slow, he explains how hindsight alters our memory.  A result that seems obvious when viewed in hindsight is remembered as being evident at the time, when in fact it was not.

No one knew what was going to happen in 2008.  Some people thought there would be a crisis, but they did not know it.  Kahneman points out that using the word “know” fosters the illusion (an unsubstantiated belief) that we understand the past, and therefore the future should be knowable.  You will not hear anyone say, “I had a premonition that the sub-prime debt crisis was overblown and knew markets would recover nicely in 2008 – but I was wrong.”  First off, it sounds silly, and secondly, most prognosticators have forgotten they ever held that belief!  Author Nassim Taleb describes a similar effect of hindsight in his book The Black Swan:  The Impact of the Highly Improbable where he introduces the notion of a narrative fallacy, to describe how flawed stories of the past shape our views of the world and our expectations for the future. . . .  Taleb suggests that we humans constantly fool ourselves by constructing flimsy accounts of the past and believing they are true.

In the same section of his book that elaborates on many manifestations of overconfidence, Kahneman goes on to describe a specific incident where he was invited to speak to a group of investment advisors.  In preparation he asked for some data and was given the investment outcomes of twenty-five anonymous stock pickers, for each of eight consecutive years.  A careful statistical analysis of their stock-picking ability found no evidence of persistence of skill – none.  “The results resembled what you would expect from a dice-rolling contest, not a game of skill.”

The fact that he could find no evidence of skill is not remarkable.  What is remarkable is that no one changed his or her beliefs when presented with the evidence.  The advisors and their superiors went on believing that they were all competent professionals doing a serious job, when the evidence clearly suggested that luck was being interpreted as skill.  Kahneman’s conclusion:

The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry.  Facts that challenge such basic assumptions – and thereby threaten people’s livelihood and self-esteem – are simply not absorbed.

Three Lessons for Investors

1.  Overconfidence may have helped cavemen survive when facing overwhelming odds of failure, but it rarely helps investors.

2.  Beware of the narrative fallacy – A reckless leader can be labeled as prescient and bold, when a crazy gamble pays off.  So consider the role of chance and luck when an investment decision turns out well.  Luck does not equal skill, and remember that even good decisions can lead to bad outcomes, when the future is uncertain.

3.  When a mistake appears obvious in hindsight, try to remember how uncertain the situation was in advance.  No one “knew” how things would actually turn out.u