How many times you have used the phrase “I knew this would happen”? Let’s say that you are watching a match and you bet that your favorite cricket team is going to win here match. Now here two scenarios are possible- first, where your favorite team wins, you are likely going to be cheery about and it and say “I knew they would win!”; Other situation could be where your team loses, your reaction will likely be “the opposition balling was too strong, I saw this coming”, implying that you knew that this was going to happen because there were signs. Though, in reality, you did not have any control or knowledge on what was going to happen, you tell you already knew. Well, you have been tricked by your brain to only recall the memories which make you feel that you are aware of what is going to happen. This in psychology is called a “hindsight bias”.
Hindsight Bias as a concept was formally introduced in 1975 by Fischoff by collecting responses of people about elections and their responses after the results. The people like our previous example said that they knew what was going to happen, though their recorded responses were different.
In this article, we start by understanding what hindsight bias is, then we look at its effect in investments and finally we look at some of the ways to overcome it.
What is Hindsight Bias?
Hindsight Bias is a psychological phenomenon that makes people believe that they have correctly predicted an outcome, even before it had happened. This leads to a sense of over-confidence in their abilities to correctly predict any event. This brings a bias in their decision making ability as they rely upon the success of decisions taken in past. According to researchers, the reason why people develop this bias is that your brain tends to make connections and patterns between the new information and the things you already know. This makes learning about a new piece of information less surprising.
Hindsight is usually considered to be harmless, an individual can retrospect and learn from their mistakes. But, having this bias in the medical, judiciary or markets can lead to serious misjudgement (In this article we will focus mainly on the effects of this bias on investors). It stems from a lot of factors like people tend to believe that things are predictable so that they can avoid being blamed for a problem. Even, the ease of understanding past outcome, which is misunderstood as the likelihood of it happening over and over.
Some particular characteristics of Hindsight bias are:
- a) Memory distortion: it means that we are selective about our memory. We tend to weave a story that helps understand the information we have. A lot of the time investors will not remember their initial judgment or predictions. After the event, they would normally react that they saw it coming.
- b) Foreseeability: This is the belief that the investors can foresee the future, they can predict what is going to happen in the market. Though in reality, no one can do that.
- c) Inevitability: Sometimes when things don’t go as per our prediction we tell ourselves, “this is the way it was supposed to be, it was inevitable”. We miss that there was an error in our judgment.
So, now that we have a fair idea of what hindsight bias is and what are its common characteristics. We’ll focus on how this bias affects the investors in the market.
Why is Hindsight bias dangerous for investors?
Stock prices change every day as a result of people buying and selling it as per their needs. Investors tend to start making patterns about how these prices are going to change over some time. This analysis of patterns makes them believe that they can predict what is going to happen in the future. This kind of analysis may be useful but it is limited in its use. If they predict some profitable investments correctly, they develop a sense of over-confidence in their judgments. They start taking riskier investments and when they end up failing they don’t see the hindsight bias rather blame it on their portfolio investors or beat themselves up for ignoring the signs.
Another example where hindsight bias can be dangerous for investors are the IPO’s. The popular view is that IPO’s are easy money. When collectively people create a buzz that it is going to be a high issue, the bias gets stronger that they knew it all along. As per the Economics Times, this analysis is not helpful for investors to make their next choice. Rather Hindsight bias helps a lot of poor quality IPO’s as they can make use of this bias and sell gullible overconfident investors buy their equities.
Investing should be based on the current set of values a company holds or the current market conditions. Not, based on the success of past judgments, which is why having hindsight bias becomes very risky for investors. It can distract investors to objectively evaluate a company. Therefore, the investor must stick to the “Intrinsic value evaluation method” (Intrinsic value refers to the perception of a stock’s true value, based on all aspects of the business and may or may not coincide with the current market value.)
Historically, it’s been observed that financial bubbles are always subjected to hindsight biases after they burst. For example, the Great Recession of 2008 and the Dotcom bubble of the late 1990s, many people said that they had accurately predicted these events. Many scholars, on the other hand, have explained that at the time the harbingers of the financial bubble were seen as trivial. If these financial bubbles were so easy to spot they could have been avoided altogether. But in reality, it is a trick that the Hindsight bias plays with our mind.
So, knowing the effects of this bias. How should we prevent it?
Having hindsight bias can either end up giving too much blame or too much credit to a person. What is noteworthy here that being aware of the bias does not make us immune to it. This something that can happen unconsciously. There are certain practices that an investor (or an individual) can take up to reduce hindsight bias.
- Opposite outcomes: Investors making a decision based on certain knowledge should always try to consider what happens if the outcome is the opposite of what they expect. The rationale behind here is that if your mind considers that there is more than one outcome possible, it is less likely that you’ll be fixated on that your prediction is the obvious one. It gives a better and a broad perspective to investors.
- Maintaining a Journal: It is a suggested practice that investors should keep a written account or diary of their forecasts and decisions. This helps in keeping a track of their investments and the factors that led to it. Therefore, keeping them from a distorted memory.
The essence of these practices to avoid hindsight bias is that, since we make this error unconsciously these practices forces our minds to consciously look at the decisions we are making.
Conclusion: Hindsight bias occurs on an everyday basis betting on games while securing a college of your choice, outcomes of political decisions, etc. It is helpful for human beings as it also acts as the ability to learn from our mistakes. But, too much reliance on the past can lead to delusions about future outcomes. In the case of investment, it can prove to be disastrous. Therefore, investors are suggested that while making the decisions they should stick to the methodologies prescribed. As Wiseman once suggested, it is better to focus on the “process than the outcome.
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