Money Sundays: On Hindsight Bias, Misremembering, and Why You Should Keep An Investing Journal

This post is VERY off-topic, even for a Money Sundays post. However, it is relevant to the often typical arrogance of experts, policy makers and elites at all levels and in all domains in our society. Feel free to skip it if you'd like.

Once an event has passed, we tend to believe that we had better knowledge of the outcome before the fact than we really did.
--Michael Mauboussin, More Than You Know

Readers, do any of you remember the name Robert Citron? To municipal bond investors and anyone from southern California, his name is impossible to forget. Citron was the former Treasurer of Orange County, CA and he's (in)famous for singlehandedly blowing up that county's finances.

Citron used residents' tax dollars to speculate in a highly leveraged portfolio of repos and floating rate notes, and his speculations drove the entire county into bankruptcy in 1994. At the time, it was the biggest municipal bankruptcy in US history.

I want to share two quotes from Mr. Citron, both made publicly, shortly before he bankrupted Orange County. First, a quote from his annual report from September 1993:

"We will have level if not lower interest rates through this decade. Certainly, there's nothing in the horizon that would indicate that we will have rising interest rates for a minimum of three years."

In February 1994, just five months later, the Federal Reserve raised rates, exactly what Citron did not expect. But here's what our buddy Citron said immediately afterward:

"The recent increase in rates was not a surprise to us; we expected it and we were prepared for it."

Okay. It is duplicitous enough to act like you "know" where interest rates are going--only charlatans claim this. But it's far worse to misremember what you said so it sounds like you were right when you were wrong all along.

Worst of all, it's astounding to see Citron misremember what he wrote publicly just months before in his County annual report, especially given that he was running a risky, interest rate-sensitive exotic bond porfolio! The arrogance here is staggering.

This is a classic example of hindsight bias. It's a common cognitive error that we all make: we conflate what we know after an unexpected event happens with what we knew before. In Citron's case, he misremembers his own expectations, which allows him, hilariously, to claim he knew all along that interest rates would increase.

Fortunately for us, we had his original prediction in print, so we know what he actually expected, and we can see that he misremembered his prediction. We had his original prediction in print. Hang on to that thought: we'll return to it shortly.

Within a few months, Citron's exotic bond portfolio--a deeply risky portfolio he had no business running at all, and certainly not with taxpayer funds--blew up. It spontaneously put the entire county into bankrupcty. Thanks to Citron's arrogance and hindsight bias, 3,000 public employees lost their jobs and the county cut budgets across all services for years to come.

Worst of all, county taxpayers are still holding the bag: they get to make extra tax payments of some $76 million per year until 2027.

So, why am I talking about this? Because in personal finance, we are all mini-Robert Citrons. We are all consistently guilty of hindsight bias. It's one of the most common cognitive errors in investing.

Granted, in our personal investing, we can't detonate entire municipalities. Thank goodness. But we can and do hurt ourselves and our families when we make prediction errors, misremember those predictions, and then fail to learn from them.

So how do we avoid overconfident decision-making, and how do we make sure that we learn from our investing mistakes rather than misremember them? How do we protect ourselves from our inner Robert Citron?

The solution is laughably easy: keep an investment journal. And use it to document the reasons behind any investment action you take.

Here's how I do it: I use a simple spiral notebook, and whenever I buy or sell a stock, index fund, ETF, or make any changes to my overall investment portfolio, I simply write down four or five bullet points on what I intend to do and why.

And when I buy any individual stock, I make sure I write a short two- or three-sentence thesis on why I want to own the company, what it does, and, most importantly, at what prices I would buy more.

One more idea: you can use your investing notebook to keep a running list of stocks, funds or ETFs that catch your eye and that might be worthy of buying under the right conditions (and yes, of course, you'll jot down 2-3 sentences on what those specific conditions would be so that later you don't misremember them!). This is a convenient way to keep a stable of potential new investment ideas.

The whole point of keeping an investing journal is to subvert hindsight bias. Your brain has a subtle but powerful desire to conflate prior predictions with new information. It wants that wonderful feeling that it knew all along. Writing down your thinking at the time of prediction preserves it, inoculating it from misremembrance.

You'll see: in the future, there will be some disruption--affecting a stock you own, a fund you've chosen or the overall investment environment--and that disruption will impact your thinking and cause it to become unmoored. At these moments, it's priceless to be able to bring yourself back to the actual documented reasons why you bought a stock or a fund. With properly moored thinking, you can actually check to see if your thesis was correct or incorrect and why. You'll be able to learn from your mistakes rather than misremember them. And you'll have a concrete plan for what you should do when an exogenous event or an unexpected market selloff occurs.

In contrast, if you merely keep your reasons in your head, you are guaranteed to misremember them. What's worse, the key problem with hindsight bias and misremembering--as with most cognitive errors--is that we really, truly, honestly believe we don't do it. We are all mini-Robert Citrons. An investing journal is just a simple device to help protect us from ourselves.

Remember Robert Citron. Note your investment decisions and the thinking behind them in your investing notebook so you won't do what he did.

Some of the ideas in this post came from Michael Mauboussin's book More Than You Know, Hersh Shefrin's book Beyond Greed and Fear, and Nicholas Taleb's book Antifragile. For further reading on Orange Country's bankruptcy see Robert Citron's Wikipedia page for useful additional context.

Read Next: Money Sundays: Is Looking For Tax-Efficient Investments Icky? Or Intelligent?

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Debbie M said...

Even more off topic, this also works for dating. After a break-up, I like to write down all the reasons for the break-up and/or all the ways we weren't good for each other. Then later if I get lonely or tempted, I can use this list to not make a mistake.

I wonder how many other things this strategy is good for.

Daniel said...

Great comment Debbie. If there's ever a domain where we misremember things, it's in relationships. That's a really good insight, thank you for sharing!


Juli said...

Great article! Thanks for the specifics of your own investment journal - those details are exactly what I needed to start one of my own.

For a while now, I have been jotting down some of my musings, ideas, and plans, as well as snippets of important information I come across, in a "financial journal", but I like the specificity of recording each purchase and the reasons behind it. (I also will likely start a "potential investments" journal as you recommended, because I sometimes put things on my watch list and then forget exactly why I did... haha)

Plus, I happened to have just made a purchase earlier today, so I started the journal off with the (very fresh in my mind) reasoning behind that purchase. :)

Sweet! Thanks, as always, for sharing your financial experience and advice with us.