“Hindsight is not 20-20. Not even close.” – Ed Catmull
I recently read the book Creativity Inc by Ed Catmull who is one of the cofounders of Pixar and the current President of both Pixar and Walt Disney Animation Studios. The book looks at the events leading up to the formation of Pixar as well as the road blocks which almost derailed the company before it ever had a chance to create the first completely computer animated motion picture. In the book, Ed explains how he and his fellow co-founders were very intentional in building a culture at Pixar where creativity could flourish, which he attributes as the main reason for Pixar’s success. Today’s post was inspired by one of the sections from Creativity Inc which looks at our tendency as humans to fall prey to what is known as the hindsight bias.
I would venture to say that everyone has heard the phrase, “hindsight is 20-20” and most, if not everyone, reading this post believes this to be a true idiom. As such, imagine my surprise when I read the following from Creativity Inc.
“Hindsight is 20-20.” When we hear it, we normally just nod in agreement – yes, of course – accepting that we can look back on what happened, see it with total clarity, learn from it, and draw the right conclusions. The problem is, the phrase is dead wrong. Hindsight is not 20-20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we see what happened clearly – hindsight being 20-20 and all – we often aren’t open to knowing more. (emphasis added)
In isolation, this paragraph may seem far-fetched, but Ed goes on to explain why our memories of the past are far from reality. It turns out that only about 40% of what we “see” every day comes in through our eyes. That means that the remaining 60% of what we see around us comes from our brain filling in the gaps based on past experiences and recognized patterns. As such our view of the world and our recollection of historical events is greatly influenced by things that have happened to us in the past. For example, someone who has been mugged before may have the perception that their city is a much more dangerous place to live than someone who has not. By the same token, the person that has been mugged may intentionally cross over to the other side of the street when they see what they believe is a shady character in their path, whereas the person who hasn’t had the same experience in the past may ignore it completely. Again from the book:
We know that in plotting our next move, we are selecting paths into the future, analyzing the best available information and deciding on a route forward. But we are usually not aware that when we look back in time, our penchant for pattern-making leads us to be selective about which memoires have meaning…We build our story – our model of the past – as best we can.
All we need is a tiny bit of information to make huge leaps of inference based on our models – as I say, we fill it in.
In other words, as human beings we like things to “make sense” so we fit the information we receive from the world around us into our brain’s model and interpret events through that lens. A great example of this and the 40% rule is the way we feel and are amazed by a magician performing sleight of hand tricks.
In order for the magic trick to work, two things must occur: First, the magician must divert our eyes from where the hidden action is actually happening; second, our brains must fill in the missing information, combining what we already know with what we are perceiving in that moment. This is a great example of the 40-percent rule…We aren’t aware that the majority of what we think we see is actually our brain filling in the gaps. The illusion that we have a complete picture is extraordinarily persuasive. However, the magician doesn’t create the illusion – we do. We firmly believe that we are perceiving reality in its totality rather than a sliver of it.
Believing that our perception of the world is very different than reality is a tough pill to swallow. But understanding this point can be extremely powerful. Not only in the way we interact with other people who have different perceptions and brain models for how they view the world, but also in our approach to investing.
Given my professional career and the fact that I think about some form of investing pretty much every day of my life (hey, I love what I do!), it wasn’t much of stretch for my brain to process the information I gleaned from this book through the lens of how it might apply to investing. If more than half of what we see and remember in life is not based on reality, but instead comes from our biased brain’s model of what the world should look like, it sets us up for being overconfident about the future based on what we “know” about the past. When it comes to investing, this can be extremely dangerous as the overconfidence born out of the hindsight bias could lead to excessive risk taking and potentially catastrophic losses.
For example, let’s say that someone was heavily invested in the stock market prior to the financial crisis and their portfolio took a huge hit before they “just couldn’t take it anymore” and sold all their stocks somewhere around the then unknown bottom. Over the next couple years they watched with painful regret as the stock market ripped upwards before they decided to wade back into the market using some sort of strategy with built in risk management (something like MarketVANE for example) to avoid the pain they just went through a couple years back. Over the next several years, the fear of the sell-off waned and the frustration of “not keeping up with the market” grew. Finally, our investor decides to dump his risk-managed strategy in favor of a buy-and-hold strategy because he/she has learned from previous experience that stocks always bounce back and rise if you don’t make bad decisions by letting your emotions get the best of you.
Although this story is entirely made up and there may even be some truth in parts of it, the conclusion is far from reality for every person alive nor is it a universal truth to investing. If we look through the entirety of human history, we see that countries do collapse and stocks don’t always grow at a “long-term average rate of 10%.” That is not to say that this can’t happen, just that it might not. When we let our personal experiences shape our view of reality (an inevitability according to Catmull) and invest accordingly, risk is compounded.
Managing risk is a thankless task when viewed in the rearview mirror of a bull market. Be that as it may, we continue to invest using our Diversification 2.0 methodology which spreads risk across multiple investment types. Maybe stocks will be the best investment over the next decade or perhaps it will be hard assets like oil, gold, and real estate or maybe it will be private debt such as a portfolio of peer-to-peer loans. Our answer to this conundrum is “great” because we want to have exposure to all of the above in our portfolio. Spreading risk out through portfolio construction processes like Diversification 2.0 with a risk-management overlay like MarketVANE means that are clients’ portfolios are better positioned to weather whatever the future may throw at us. Maybe the future will look like the recent past, but maybe it won’t; either way, we want to be positioned to succeed in reaching each of our clients’ individual goals for retirement.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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