Tuesday, September 30, 2008

Hindsight Bias and Regret in Trading

"I should have caught the move"

"I knew that was going to happen"

"If only I had followed my signal"

When markets become unusually volatile, they make unusually large moves. To the short-term trader or the active portfolio manager, such moves look like phenomenal opportunity. This creates a kind of dissonance when their results do not reflect such opportunity. This dissonance is often expressed as regret: the word "should" becomes a prominent part of traders' thinking.

Underneath this regret is what behavioral finance researchers call "hindsight bias": the exaggerated sense of predictability in retrospect. Very often, traders will have reasons in mind why the market might rise and they can identify reasons why it might fall. The evidence from research, charts, fundamentals, and indicators often paints a mixed picture. In retrospect, however, traders will look back on market outcomes and selectively pick out the evidence that would have predicted the market's movements. They minimize the ambiguity that occurred at the time and convince themselves that they knew all along what the market was going to do.

It's easy to see how hindsight bias and regret go hand in hand. If you convince yourself that you saw the market move in advance and you see that you didn't participate in the move, the dissonance between what your profitability should be and what it is leaves plenty of room for self-recrimination. Out of this regret, traders often feel pressure to make up for the "missed opportunity", leading to overtrading.

A psychodynamic psychologist would view hindsight bias as a kind of defense: it protects traders from the anxieties of ambiguity and unpredictability and reinforces an illusion of control. A number of behavioral finance investigations have shown traders charts composed of random price movements; invariably traders find meaningful patterns in the randomness. For them, the anxiety may not be the market going up or down; the anxiety is not knowing what the market will do.

It takes a strong psychological constitution to tolerate such ambiguity and uncertainty. And yet, it is precisely the embrace of the market's uncertainties that allows us to be alert to risk and implement proper risk management. Hindsight bias appears to be a natural response to an updating of information regarding events; it's part of how we make sense of our world. As Richard Peterson notes in his book "Inside the Investor's Brain", research from Paul Slovic finds that the best antidote to hindsight bias is a hard, purposeful look at "counterfactuals". Once a market event occurs, considering the array of alternative outcomes and their implications helps moderate hindsight bias and associated regret.

Given the limits of what we know and what is ultimately unknowable, not all movement is opportunity. The key to trading success is finding the patience to capitalize on those things you do know and the wisdom to accept what is uncertain.