What Is Hindsight Bias?
Hindsight bias is a psychological phenomenon in which individuals tend to overestimate their own ability to have predicted an outcome that they would have been unable to predict before an event took place. Hindsight bias can lead an individual to believe that an event was more predictable than it actually was, and can result in an oversimplification in cause and effect. Hindsight bias is studied in behavioral economics.
Understanding Hindsight Bias
Hindsight bias is a fairly common occurrence in investing, since the pressure to time the purchase of securities in order to maximize return can often result in investors feeling regret at not noticing trends earlier. For example, an investor may look at the sudden and unforeseen death of an important CEO as something that should have been expected since the CEO was having severe health issues.
- Hindsight bias refers to the tendency of an individual to believe that he or she would have been able to accurately predict a previous outcome, even if that person was unable to do so in real time.
- This phenomenon originates in psychology but plays a crucial role in behavioral economics as well.
- In investing, hindsight bias may manifest as a sense of frustration or regret at having not predicted a trend in a security or the market overall.
Financial bubbles are often the subjects of substantial hindsight bias. Following the Dot Com bubble in the late 1990s and Great Recession of 2008, many pundits and analysts tried to demonstrate how what seemed like trivial events at the time were actually harbingers of future financial trouble. If the financial bubble had been that obvious to the general population, it would likely have been avoided altogether.
Investors should be careful when evaluating how past events affect the current market, especially when considering their own ability to predict how current events will impact the future performance of securities. Believing that one is able to predict future results can lead to overconfidence, and overconfidence can lead to choosing stocks not for their financial performance but for personal reasons.
Hindsight Bias and Intrinsic Valuation
As mentioned above hindsight bias can lead investors away from a more objective analysis of a company. Sticking to intrinsic valuation methods can help an analyst ensure that he or she is basing an investment decision on data-driven factors and not personal ones. 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.
Intrinsic valuation will typically take into account qualitative factors, such as a company’s business model, corporate governance and target market, along with quantitative ones (e.g. ratios and financial statement analyses) to determine whether the current market price is accurate or if it is overvalued or undervalued. Analysts generally use the discounted cash flow model (DCF) to determine a company's intrinsic value. The DCF will take into account a company's free cash flow and weighted average cost of capital (WACC).