Probably somewhere in these theories is the answer to your question:  “why did I make that pick?!?”  Choice-supportive bias, the tendency to remember one’s choices as better than they actually were, helps explain “I think I picked that upset.  Oops, no I didn’t” and “I almost made that pick.”

However, the concept I want to focus on today is hindsight bias, the tendency to view things that have already happened as being relatively predictable at the time those events happened (also called the “I-knew-it-all-along” effect).  In the NCAA Tournament, it manifests itself when we look back and it seems so apparent why a team advanced over another team.  It makes sense that fourth-seeded Louisville made the Final Four.  They were riddled with injuries during the regular season, but put it together to win the conference tournament in the powerhouse Big East and were playing with a lot of confidence¹.  It makes sense why a mid-major team with a group of seniors beats a talented, but inexperienced team from a major conference. 

We believe it was so obvious what we should have done the last time, that we now know what to do the next time.  However, how often have these “lessons” actually led you to truly improve your brackets in each succeeding year? 

Hindsight bias not only exists during March Madness and in research studies, but also in investing.   When a conversation comes around to the financial crisis and bear market of 2008-2009, a lot more people happened to “see it coming” now than actually did in 2008.  It also leads them to have a lot more confidence that they will know when the next big crisis is coming.  And it holds true for individual stocks as well:  “how could you not know?”

In the NCAA Tournament, there are just too many variables, too many moving parts, that exist in any one game, any one tournament.   That’s one of the reasons they call it March Madness.  The same holds true in the markets.  In this world of global interdependency, there are so many things that can impact the market that cannot be predicted, that it is virtually impossible to do so with any consistency. 

Yet when we allow ourselves to be influenced by hindsight bias, we tend to think we can better know what to do the next time.  We think we’ll know when to get in and out of the market; that we’ll see the pattern; we’ll know which IPO will be the winner.  Hindsight bias can lead to overconfidence in our own abilities, but ultimately, to the detriment of our long-term financial success. 

¹  Not one of ESPN’s 15 “experts” predicted Louisville to make the Final Four.  In fact, 9 of the 15 (60%) predicted No. 2 Missouri would, who ingloriously lost to No. 15 Norfolk State in its first tournament game.  Our own Jeff Malbasa however, did pick Louisville, and has a dominating lead in our office pool (I picked Missouri).

In a recent blog, I opined about confirmation bias, the tendency to give more weight to information that supports your current position and downplay or ignore information that is at odds with our preconceived notion.  Nowadays, I find that bias prevalent when a conversation comes around to Apple, Inc. and its stock performance, especially as Apple surpassed Exxon as the most valuable U.S. company.  I’ve heard or read things such as “nothing can stop Apple” or “as long as they continue to put out products that are second to none, Apple will be a good investment.” 

While Apple no doubt has been a good investment for shareholders in the past and the company’s popularity with consumers continues to grow, it is important to point out “what could go wrong” to combat confirmation bias in your investment decision-making looking forward.  Overall, I’d break these risks into three categories (for Apple or any other stock you may own).

Things over which the company has little control

The list of possibilities includes things like fraud, embezzlement or other unethical behavior.  I’d also throw litigation into this category, including anti-trust regulation.  The loss of a key employee can also be impactful, either by being lured away to another company or, as in the case of Steve Jobs, due to death. 

Another example might be a significant disruption in the production process, including a natural catastrophe, foreign government influence (e.g., China) or labor market dispute.  You could argue that Apple can limit the possibility of many of these things, which is true, but the fact of the matter is they have the ability to influence their results, which leads me to my second category…

Failure to deliver on corporate performance

First, there is risk that the management team is unable to execute on its vision.  This has certainly become more of a concern with the passing of Steve Jobs, who relentlessly pursued his vision and drove corporate initiatives.  Although the management team is talented, the question remains whether they can uphold the passion for innovation and success in future product development.

Second, while the company has grown revenues at the rate of more than 33% per year over the last decade, it becomes harder and harder to maintain that level of growth.  With over $100 billion in sales in Fiscal 2011, revenues would need to grow to almost $2 trillion per year over the next ten years to maintain this level of growth.  Somewhere along the line, profit margins may begin to get squeezed in order to maintain growth.  In short, it can become a victim of its own success, which leads me to #3…

A great business does not necessarily mean a great investment

While our stock selection philosophy is based on a belief that corporate performance is a driver of stock price performance, it is also incredibly important to understand the performance a company must deliver to justify its current stock price.  If corporate performance cannot keep pace with embedded expectations, the stock is likely to underperform.  As Warren Buffett has said, “price is what you pay, value is what you get.”

Not that long ago a friend commented that in the late 1990s he started tracking a number of the stocks from Jim Collins’ book Built to Last which studied companies that had been premier institutions in their industries and widely admired while they made an imprint on the world around them.  Yet over the next decade, this basket of stocks underperformed Spero-Smith’s more diversified equity portfolio.

Now I am not an “early adopter” when it comes to technology, but I have come to appreciate Apple as one of the most innovative developers of consumer products and services in the tech sector.  And as a firm, we have weighed the incredible opportunities for future growth and continued strong corporate performance versus the risks and in our judgment, Apple still represents a good investment.  In fact, it is one of the largest holdings in most stock-based portfolios and fund-based portfolios (when you consider the underlying holdings of each manager we employ).

However, owning the stock is not without its risks.  Even though it has been a tremendous wealth creator historically, there is no guarantee that it will continue to do so.  And that is why we continue to own it as just a small part of a well diversified portfolio.  By the way, if at any point you were reading through the “what could go wrong” points and thought to yourself “yeah, but this is Apple…it won’t happen to them,” you are displaying just a little bit of that confirmation bias.

 Light vehicle sales in the U.S. have picked up notably in recent months and now are running at an annualized (and seasonally adjusted) rate of 15.1 million, the highest level in four years.  As shown in the graph, annualized sales had dropped below 10 million during the recent 2008-2009 recession, which was the lowest level since the 1982 recession.  Just prior to the recent recession, the decade ending in 2007 was a boon for the vehicle industry with annualized unit sales of nearly 17 million.

             The fact that unit sales registered a one-month jump of 6.5% in February, following a 4.6% gain in January, indicates a growing confidence among consumers, even amidst rising gasoline prices.  Auto sales are watched as an early indicator of U.S. consumer demand and a willingness to finance big-ticket purchases.   And since the average car on the road in the U.S. is a record 10.8 years old, there is still a lot of pent-up demand.  The higher price at the pump has undoubtedly contributed to a shift in purchases to smaller cars:   23% of new-car sales in February were small cars, up from 17.9% in December.