Investing can often feel like navigating a maze. Looking back at our investment decisions, everything seems clear and straightforward. This illusion of hindsight can make the complexities and challenges of investing seem deceptively simple.

However, when we are in the thick of making decisions, we face numerous obstacles, unknowns, and uncertainties that can cloud our judgment and make even the most well-planned strategies seem daunting.

It's easy to view past investments as obvious successes or failures, forgetting the volatility and uncertainty that were present at the time.

This hindsight bias can lead to overconfidence and a dangerous underestimation of the risks involved.

Volatility and uncertainty are constants in the investment landscape, lurking just beneath the surface even when markets appear calm.

Drawing from my extensive experience as a portfolio manager, where I managed equity and asset allocation strategies for large institutional investors as well as for wealthy individuals, I have seen firsthand how easy it is to fall into the trap of hindsight bias.

In this note, we will explore the psychology behind the illusion of hindsight, delve into the inherent volatility and uncertainty of investing, and offer actionable advice for navigating these challenges.

Most importantly, we will focus on cultivating a resilient investment mindset that can withstand the ups and downs of the market. By embracing the realities of investing and preparing for the unexpected, we can make more informed decisions and ultimately achieve greater financial success.

The Psychology of Hindsight in Investing

The human mind is wired to find patterns and make sense of past events, often leading to the illusion that things were more predictable than they actually were.

This is known as hindsight bias. Hindsight bias can distort our perception of past decisions, making us believe that market movements were obvious and predictable.

For example, consider the dot-com bubble of the late 1990s. At the time, many investors were caught up in the euphoria of rapidly rising technology stocks. It seemed as if these investments were a sure thing. However, when the bubble burst in 2000, hindsight made it appear obvious that the market was overvalued. Investors looking back often think, "I should have seen that coming," but the reality is that during the boom, the risks were not as apparent.

Similarly, the 2008 financial crisis provides another clear illustration. Before the crisis, housing prices were soaring, and mortgage-backed securities were considered safe investments. In hindsight, the warning signs of an impending collapse seem clear, yet during the time, these risks were underestimated by many investors.

As a portfolio manager with over 30 years of experience, I have witnessed the impact of hindsight bias on investment decisions.

Investors who fall prey to hindsight bias may become overconfident, believing they can predict market movements more accurately than they actually can.

This overconfidence can lead to taking on excessive risks, assuming that future investments will be as predictable as they appear in hindsight.

Understanding Volatility and Uncertainty

Volatility and uncertainty are the bedrock realities of investing. These elements are ever-present, affecting markets in ways that can be both visible and hidden. Understanding and accepting these factors is crucial for any investor aiming to build a resilient portfolio.

Volatility refers to the degree of variation in the price of a financial instrument over time. It's often seen as a measure of risk, with high volatility indicating greater uncertainty about future price movements. For instance, during the 2008 financial crisis, the VIX, often referred to as the "fear index," spiked to record levels, reflecting the extreme uncertainty and anxiety among investors.

Uncertainty, on the other hand, encompasses the unknown factors that can impact the market. It includes everything from geopolitical events and economic shifts to company-specific news and technological changes. Unlike volatility, which can be quantified, uncertainty is harder to measure but just as significant in shaping market behavior.

Why Volatility and Uncertainty Matter

During my career managing portfolios for institutional investors and wealthy individuals, I’ve seen how volatility and uncertainty can both create and destroy value.

For example, during periods of low volatility, such as the mid-2000s, markets can appear deceptively stable. Investors might become complacent, forgetting that calm periods often precede significant market shifts. This was evident when the housing bubble burst, catching many off guard despite the apparent stability in the preceding years.

The dynamic of today’s markets is similar to that of the mid-2000s. Volatility metrics are at historical lows and investors seem overly complacent. Rising equity markets with low volatility have a way of lulling investors to sleep.

Investing amid uncertainty is a challenge that even the most seasoned investors face. The key is not to eliminate risk—an impossible task—but to manage and mitigate it effectively.

Here are practical steps to help you navigate investment uncertainty and build a resilient portfolio.

1. Diversification: The Cornerstone of Risk Management

Diversification is the process of spreading investments across various asset classes, sectors, and geographic regions. This strategy helps mitigate risk by ensuring that the performance of a single investment does not unduly impact the entire portfolio.

Example: During the 2008 financial crisis, portfolios heavily concentrated in real estate and financial stocks suffered massive losses. In contrast, those diversified across different sectors, such as healthcare, technology, and consumer goods, experienced less severe declines. By diversifying, you reduce the risk associated with any single investment and increase the likelihood of achieving more stable returns.

Actionable Tip: Regularly review your asset allocation and adjust as needed to maintain diversification. Use tools like mutual funds or exchange-traded funds (ETFs) to achieve broad exposure across multiple asset classes.

2. Regular Portfolio Reviews: Staying Aligned with Your Goals

Markets and personal circumstances change over time, making regular portfolio reviews essential. These reviews help ensure your investments remain aligned with your financial goals and risk tolerance.

Example: Suppose you initially allocated a significant portion of your portfolio to equities due to their growth potential. As you approach retirement, your risk tolerance may decrease, prompting a shift towards more conservative investments like bonds.

Actionable Tip: Conduct semi-annual or annual portfolio reviews. Rebalance your portfolio by selling overperforming assets and buying underperforming ones to maintain your desired asset allocation.

3. Setting Realistic Expectations: The Key to Long-Term Success

Understanding that all investments come with inherent risks is crucial. Setting realistic expectations about potential returns and being prepared for market volatility can prevent panic and impulsive decisions during downturns.

Example: Historical data shows that equities generally offer higher returns than bonds over the long term but come with greater volatility. By acknowledging this, investors can maintain a long-term perspective and avoid panic selling during market dips.

Actionable Tip: Educate yourself about the historical performance of various asset classes. Set achievable financial goals and create a plan that balances growth potential with risk management. Being “good enough” is fine as perfection is an unachievable expectation!

4. Embracing a Long-Term Perspective: Weathering Short-Term Volatility

Maintaining a long-term perspective helps investors withstand short-term market fluctuations. Historically, markets tend to recover and grow over extended periods, even after significant downturns.

Example: The S&P 500 has experienced numerous bear markets and corrections, yet it has consistently trended upward over decades. Investors who stayed invested through these downturns achieved substantial long-term gains.

Actionable Tip: Develop a long-term investment plan and stick to it, even during market downturns. Focus on your overall financial goals rather than short-term market movements.

5. Leveraging Expert Advice: Balancing DIY with Professional Insights

While DIY investing offers control and cost savings, seeking expert advice can provide valuable insights and help avoid common pitfalls. Learning from seasoned professionals who have navigated various market cycles can enhance your investment strategy.

Example: As a former portfolio manager, I’ve seen the benefits of combining quantitative analysis with company and economic fundamentals. This hybrid approach can provide a more comprehensive view of the market and improve decision-making. I have also sought the perspectives of others to keep me balanced and aware of the risks embedded in my portfolio.

Actionable Tip: Consider consulting with a financial advisor for periodic reviews of your investment strategy. Even occasional expert input can provide new perspectives and help refine your approach.

Cultivating a Resilient Mindset

Investing successfully requires more than just technical knowledge and strategies. It also requires a resilient mindset capable of withstanding the inevitable ups and downs of the market.

Emotional resilience helps investors stay calm during market downturns and avoid rash decisions that can jeopardize long-term financial health.

Here are tips for cultivating a resilient investment mindset:

• Practice mindfulness and stress management techniques to help stay calm during market fluctuations. Develop a set of rules for when to buy or sell investments, and stick to them regardless of market conditions.

• Continue to educate yourself. Regularly read financial publications such as The Economist and the Wall Street Journal. The more financially educated you become the better you’ll be able to deal with market fluctuations.

• Establish clear, achievable financial goals based on your risk tolerance and time horizon. Regularly review and adjust these goals as needed to stay on track. Don’t compare yourself to others. The only goals that matter are the ones that you come up with.

• Create a long-term investment plan and commit to it. Avoid checking your portfolio too frequently, as this can lead to unnecessary stress and impulsive decisions. Sometimes looking away is the best course of action.

• Keep a record or journal of your investment decisions, noting the rationale behind each choice and the outcomes. Reflect on past mistakes to identify patterns and areas for improvement. Figure out your triggers.

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the rise in interest rates starting in 2022.

• Over the last three years, the GF Low-Risk strategy is only up 1.1% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.7%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 2.7% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 6.4%.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, precious metal prices have joined the party providing a further boost.

• Over the last 5 trading days, international equity strategies have performed best.

• Domestic fixed-income strategies are recovering as long-term rates are showing some downward bias as inflationary expectations trend down and the Fed prepares to cut rates.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns: Expect slightly lower than normal equity and bond market returns given valuation conditions

Risk: Diversify with alternative assets, market volatility has been significantly below historical measures

Equity Risk: Asset allocation portfolios are dominated by equity market risk, no different from the past.

A Bit of Wisdom Never Hurts

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this blog are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.