Spoiler Alert: You probably didn't.

How often have you heard someone say, “I just knew that was going to happen . . . but it didn’t.” People seldom admit, even to themselves, that their intuition was wrong or that they didn’t see something coming. What you are much more likely to hear (and to say) is, “I just knew that was going to happen and I was right.” As we explain to ourselves why we were right, the events that have just happened take on the certainty of inevitability, and our confidence in our intuition and judgement is bolstered. If, on the other hand, we didn’t anticipate an event that in hindsight seems perfectly obvious, we blame ourselves for not seeing the inevitable outcome and are tortured with remorse.

In fact, the world is full of random, unpredictable events. Even when a big picture analysis indicates that certain outcomes are very likely—mass shootings in the United States, for example, or the bursting of a market bubble—it is still impossible to predict when and where they will happen. Rather than accepting the painful premise of an unknowable future, our tendency is to build a coherent story for why something happened that fits our current world view, even if that means altering beliefs that we formerly held. Even though the story we tell ourselves may be a pessimistic one, maintaining a belief that something was a foregone conclusion makes us feel secure in our ability to predict the future.

We have a need to feel in control of what is happening to us, and random or unpredictable events are frightening because they suggest a world beyond our control. For that reason, our minds work hard to find meaningful patterns and make sense of our experiences in the world, rapidly piecing together the information that is available to us in any given moment. The less we know about a situation, the easier it is for us to construct a credible explanation of what happened, because limited knowledge means that we are dealing with fewer complexities. Furthermore, this pattern-making process involves constantly revising our interpretations—and even our memories—of the past in the light of our new knowledge and assumptions. Psychologists tell us that we subconsciously distort our memories of what we believed would happen in order to align them with actual events. We then have difficulty remembering what we used to believe, making it easier to convince ourselves that we have predictive abilities.

Furthermore, in making predictions about the future, we tend to heavily weight events that are most recent in our memories. In other words, we expect the future to closely resemble the recent past. This can cloud our judgement and even our ability to perceive pertinent information, since our tendency is to look for events to confirm our beliefs and assumptions; and to ignore, or fail to see, what we are not looking for. A fun example of selective attention at work is demonstrated in a YouTube video where viewers are asked to count the number of times members of the basketball team in white pass the ball. Try it for yoursel at this link.

A more serious demonstration of the effects of selective attention is a general reluctance to invest in stocks after the credit crisis of 2007/8, in spite of a strong market recovery. Although returns in 2012 were healthy—David Weidner in the December 26th edition of the Wall Street Journal reported that the Dow Jones Industrial Average is up more than 7%; the S&P 500 Index has gained more than 13%, and the Nasdaq has added more than 15%—investors, and the pundits who fill columns in the daily financial press, continue to ignore current evidence and shy away from the markets. As a result, instead of adding substantially to the value of their portfolios, loss-averse investors who have stuck with ‘risk free’ bonds or sat on their cash have earned almost nothing.

The tendency to focus on the recent past also encourages a focus on the short term. This can lead to disastrous investment results, as investors fall prey to impulse buying and panic selling instead of drawing on the resilience needed to ride out the long-term cycles of the market.

As always, awareness of our inherent biases helps to guard against faulty decision-making. One approach is to keep a diary: as an investor, you might note your thinking and assumptions when making a particular investment. Then, when you experience the feeling of, “I knew all along this was going to happen,” you will have a record of what you actually believed at the time you made your decisions. In addition to alerting you to any dangerous overconfidence in your power to predict the future, this will give you the opportunity to analyze your assumptions and thought processes, and an awareness of where your strengths and weaknesses lie.

At other times when you berate yourself with, “How stupid of me not to have seen this coming”, you can counteract the tendency to focus on one explanation of why an event occurred while ignoring the other possibilities. Thinking through alternative outcomes that were equally plausible and possible at the time you made the decision, without the perfect vision of hindsight, will allow you to evaluate whether your decision-making process was sound, rather than focusing on whether that particular outcome was good or bad. As Nobel Prize winning economist Daniel Kahneman writes in Thinking Fast and Slow, “Hindsight is especially unkind to decision-makers who act as agents for others: we are prone to blame decision-makers for good decisions that worked out badly and to give them too little credit for successful moves that appear obvious only after the fact.”

As investors, we need to discipline ourselves to make our investment decisions based on the findings of financial science and our personal financial goals for the future, rather than relying on an instinctive (and flawed) interpretation of our recent experience and projection into the future.

This article by Daryn Form was published in the February 2013 edition of Sask Business Magazine.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.