Hindsight: 20/20 or not?

One of the most powerful forces in investment psychology is hindsight bias – to view events as more predictable than they really are. We have a natural tendency only to remember when our predictions turned out to be correct. We conveniently forget (or deny) the many events we predicted incorrectly.

Let’s go back to March 2009, the time when share prices were obviously undervalued (in hindsight of course). On closer inspection many professionals actually believed that shares were undervalued, but here is the catch – very few expected prices to recover in the near term. Bad economic news prevailed which kept buyers away to bid prices up.  (This article is a classical example of many ‘expert’ opinions in bear market lows.)

Calling the bottom

Last year I re-read Martin Zwieg’s book Winning on Wall Street. Here is an extract of chapter 8:

“Bad news is making headlines . . . It’s amid such doom and gloom that bear markets bottom and bull markets begin, meaning that the vast majority is wrong, precisely at the bottom . . . with the economy collapsing, the Federal Reserve [RBA in Australia] will usually begin loosening credit, and interest rates will start to fall . . . the worst results for corporate earnings usually lie ahead . . . The best gains made in bull markets tend to come in the first six months of a fresh bull market, when profits are usually declining. So it’s difficult for investors to be optimistic when they’re staring at a terrible outlook for corporate earnings . . . Moreover, the sharp drop in interest rates will usually stimulate the economy six to twelve months down the road. . . So, the shrewd investor, going against the crowd behaviour, has two clues near a bear market bottom: first, extraordinary pessimism among the crowd at the bottom, and second, continued scepticism during the first sharp rally in the bull market.”

The year 2009 panned out almost exactly like Martin Zwieg has written more than 20 years ago. Was it coincidence? Will the next bear market be the same? I don’t know. In an uncertain environment I prefer to work with probabilities. Based on Zwieg’s rational reasoning I knew that the probability of a strong bull market in 2009 was high. It could have been different, but this time it wasn’t.

I personally made the mistake of calling the lows with much confidence in November 2008 when the All Ordinaries was around 4,000 points. Actually, I bought into some companies before the October stampede as valuations seemed good to me and many directors were also starting to buy shares in their own companies. One of the many factors I underestimated in last year’s market collapse were the number of desperate sellers having margin calls. On top of that many buyers went into hiding waiting for better economic news and many were aware not to ‘catch a falling knife’.

The secret to investment success is not to be right all the time – it’s about analysing a situation based on facts and drawing rational conclusions about the probability of subsequent events happening, regardless of what the crowd and ‘experts’ are telling you. Being a contrarian investor doesn’t mean that you always have to go against the crowd. The crowd is sometimes right, but mostly not.