By Guest Blogger Doug Rowat
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Anyone remember Alexandre Daigle?
Daigle was a ‘sure thing’ future NHL offensive superstar when he was selected first overall by the Ottawa Senators at the 1993 NHL draft. He went on, of course, to become a spectacular bust, scoring only 129 goals in 616 NHL games with perhaps his most noteworthy career highlight occurring off the ice when he was thrown off a team flight for joking about an on-board bomb.
It’s easy to laugh at the Senators now and conclude that Daigle was an obvious poor selection, especially given that three of the remaining four picks rounding out the top five that year went on to become Hall of Famers. But the key word here is “obvious” and this is the mistake almost everyone makes, especially investors, when looking back at history. Most outcomes only seem obvious in hindsight.
In 1993, there was nothing obvious about Daigle’s eventual failure. Daigle lit up the Quebec Major Junior Hockey League, including scoring 137 points (with a league-leading 2.58 points per game) in his final full season. To put this in perspective, this year’s almost-certain #1 pick (the NHL draft goes next week) and the latest ‘sure thing’ prospect, Alexis Lafreniere, led the QMJHL this year with only 112 points (2.15 points per game). Daigle also played brilliantly amongst the best players in the world in his age group at the World Junior Championships, winning a gold medal the same year that he was drafted.
And, generally speaking, taking the most-hyped player in any draft year is a pretty safe bet. Consider the #1 draft picks from 2005 to 2015 (I exclude more recent #1s because they haven’t had enough time to prove themselves): the list includes eight probable Hall of Famers, including Sidney Crosby, Patrick Kane and Connor McDavid. In other words, for many reasons, the Senators picking Daigle first overall was a reasonable decision.
But this is what’s at the core of hindsight bias: overlooking the sound rationale behind an ultimately mistaken decision and presuming that the better decision (in this case, selecting someone besides Daigle) was unambiguous. But looking back smugly after the fact and declaring that the eventual results were “obvious” can lead to poor and overconfident decisions in the future. Psychology Today sums up the cost of hindsight bias best:
You rewrite history, so to speak, and revise the probability in hindsight. Going forward, you use that new, higher probability to make future decisions. When, in fact, the probabilities haven’t changed at all. Hindsight bias can make you overconfident. Because you think you predicted past events, you’re inclined to think you can see future events coming. You bet too much on the outcome…and you make decisions, often poor ones, based on this faulty level of confidence.
Now, let’s bring this all back to investing. You might remember 2015? Seems like a simpler time compared to 2020, but if you recall it was a rough year for the Canadian equity market. The S&P/TSX Composite dropped more than 8% that year and significantly underperformed the S&P 500, which actually managed a modest gain. Starting in the spring of 2015, the TSX also had a short-lived, but still unpleasant, 15% correction.
A former client emailed me near the end of 2015 and stated that the correction in the S&P/TSX Composite “was pretty much announced” and that I should have easily anticipated it. I responded bluntly that corrections tend to be of short duration and we’ll never be able to dodge these pullbacks on a consistent basis. In short, I stated that we manage investments for the long term.
I also highlighted many of the sudden and unexpected events that caused the correction, including a slowdown in China growth, which took the WTI oil price down almost 40% in a span of only 52 days (and helped plunge Canada into a mild recession), confusing Fed interest-rate-policy guidance that roiled markets (recall that Janet Yellen was still learning the ropes back then) and two Bank of Canada rate cuts, the first of which not one analyst on the Street was forecasting. To make matters worse, this client was also arguing that I should have had most of his money in the S&P 500 at the start of the year—the index that, of course, performed better. In other words, he suggested that I should have put most of his eggs in one basket.
When you work in the investment industry long enough, you realize that nothing is “pretty much announced” and nothing is obvious. Commenters on this blog regularly imply that they’ve predicted past market shakeups long before they occurred, Covid-19 being a recent example. But, of course, no one (well, maybe Bill Gates) was predicting a global pandemic in 2019. A pandemic only seems foreseeable now because we’re currently living through one. But cue the hindsight bias: there’s suddenly no shortage of bold and confident predictions about what happens next with Covid-19.
More interesting still are all the investment firms that meet with me regularly to make sales pitches and claim that their firm saw the 2008-09 financial crisis coming and took steps to avoid it early. With all these correct predictions of the financial crisis it’s amazing that it occurred at all.
Investors need to recognize that forecasting is enormously complex and resist the urge to assume that what has already occurred was easily foreseen. It was not. And this is why every portfolio should be well diversified.
Now we’ll have to wait a year for the results, but through a simple exercise we can confirm not only the near impossibility of precise forecasting, but also help to diminish the ill effects of hindsight bias by relieving you of some of your investing overconfidence.
Okay, blog dogs, this is your challenge:
Let’s take three major indices: The STOXX Europe 600, the Nasdaq and the S&P/TSX Composite. For each, estimate their percentage gains over the next year. Secondly, rank them in order, best to worst. And finally, because these outcomes seem so “obvious”, assume that you will put all of your available funds into only the ONE index that you believe will do best. Write your forecasts into the comments like so (in whatever order you believe is correct):
1. Nasdaq: XX%
2. S&P/TSX Composite: XX%
3. STOXX Europe 600: XX%
You may feel confident at present with your forecasts; however, this confidence is unlikely to last.
A year from now it’s a virtual certainty that your percentage gain or loss estimates will be off wildly, it’ll be unlikely that you’ll have ranked all three indices correctly and also probable that you’ll have paid a price by concentrating your eggs in one basket. You may not even end up getting the overall direction of the three markets correct (e.g., the indices ended up declining when you were forecasting a gain).
But don’t take my word for it. We can all check back a year from now and see how you did. You can tell me then whether or not I was correct in my assertion that forecasting is incredibly difficult.
And, while we’re waiting out that year, let’s cheer for Alexis Lafreniere. I’ve seen him play–he’s an awesome talent. And I hope he has a better time of it in the NHL than Daigle did.
But if he ends up sucking, please, please don’t tell me that you knew it all along.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.
