The shape of retirement is changing. As life expectancy increases and retirement lasts longer, more intensive and intentional retirement planning is required. Many individuals planning to retire are focusing less on corporate retirement options and more on individual retirement planning. This requires individual investors to take great care in understanding the principles of investing, as they rely on these decisions to fund their retirement.
Many investors, though, make a common mistake. They tend to focus on the outcome of a past investment without considering the factors behind it. This is commonly known as “outcome bias” and can be highly detrimental to investment decisions.
When an investor judges a decision based solely on the outcome, and does not examine the conditions that existed at the time of the decision, the decision-making is skewed. Whether it is realized or not, knowing the outcome of a past decision influences the current opinion.
When the decision was made, a different set of information was available. The outcome was not known. Therefore, basing one’s course of action on the outcome of a past decision, rather than observing all the details that contributed to it, does not lead to strong decision-making.
A good outcome can come from a bad decision and a bad outcome can come from a seemingly good decision.
For example, an investor, Al, heard that his colleague, Sue, made great returns on a recent real estate investment. Simply looking at her returns, Al decides to also invest in the real estate market. He does not look at the interest rates or the state of the economy when Sue made her investment. Instead, he only bases his decision to invest on her success. Because Al did not take every piece of the puzzle into account, he ends up investing right before the real estate crash in 3008 and suffers a loss.
Only focusing on the money Sue made, and not the factors that contributed to her success, led Al to make an un-wise investment.
Looking at the past performance of a fund is not enough to make a wise and well-informed decision. One must consider what a fund manager or financial adviser did to achieve returns. All aspects of success should be dissected. Again, one piece of the puzzle is not enough. An adviser might manage funds well, but why? What separates one financial adviser from another? Did luck or skill provide outcomes?
A good financial adviser will measure and manage risk rather than just chase returns. They should build well-researched, broadly diversified portfolios that will weather the ups and downs of the market and focus on the long-term outcomes.
Individual investors, when making investment decisions, should focus on all of the details of success if they want to avoid outcome bias. It is wise to pay attention to valuations and historical prices, not just recent returns and performance. It is also important for investors to sit down with their investment adviser and examine the factors that go into making a decision.
Consider the process an adviser has in place for choosing investments, and try to focus on the long-term outcomes, rather than just the recent ones.