What Is Hindsight Bias?
Hindsight bias is a psychological phenomenon that allows people to convince themselves after an event that they accurately predicted it before it happened. This can lead people to conclude that they can accurately predict other events. Hindsight bias is studied in behavioral economics because it is a common failing of individual investors.
- Hindsight bias is a psychological phenomenon in which one becomes convinced they accurately predicted an event before it occurred.
- It causes overconfidence in one's ability to predict other future events and may lead to unnecessary risks.
- Hindsight bias can negatively affect decision-making.
- In investing, hindsight bias may manifest as a sense of frustration or regret at not having acted in advance of an event that moves the market.
- One key for managing hindsight bias involves documenting the decision-making process via a journal (e.g. an investment diary).
Understanding Hindsight Bias
Hindsight bias is when a person looks back and at an event and believes they could have predicted the outcome. This means that most people believe their judgment is better than it is. The idea is, that once we know the outcome it’s much easier to construct a plausible explanation. With this, we become less critical of our decisions, leading to poor decision-making in the future.
Investors often feel pressure to perfectly time the buying or selling of stocks in order to maximize their returns. When they suffer a loss, they regret not acting earlier. With regret comes the thought that they saw it coming all along.
In fact, it was one of the many possibilities that they might have anticipated. Whichever one of them pans out, the investor becomes convinced that they saw it coming. This allows investors to unknowingly make poor decisions going forward. Preventing hindsight bias involves being able to make predictions beforehand, such as keeping a decision-making journal, allowing the investor to compare later.
Keeping an investment journal or diary may allow investors to avoid some of the issues tied to hindsight bias.
What Causes Hindsight Bias?
Hindsight bias occurs when new information comes to light about a past experience—changing how we recall that experience. We selectively remember only the information that confirms what we know or believe to be true. Then, if we feel we already knew what would happen all along, we fail to carefully review the outcome (or the reason for the outcome).
Hindsight bias involves revising the probability of an outcome after the fact. After knowing the outcome, a person will exaggerate the extent they predicted the outcome. These biases can be found in just about any situation, including predicting the weather or elections.
Hindsight bias is rooted in overconfidence and anchoring. After an event occurs, we use the knowledge of the outcome as an anchor to attach our prior judgments to the outcome. The issue may be partly science-based as well. Where hindsight bias might not be solely tied to the ineffective processing of information, but rooted in adaptive learning and has evolved evolutionary. In the process of updating previously held knowledge, the brain can help prevent memory overload.
Individuals and society are susceptible to hindsight bias because it’s comforting to think that the world is predictable, and thus somewhat orderly. As a result, we seek to see unpredictable events as predictable. We seek to have a positive view of ourselves and thus use sensemaking to create a story or narrative that shows we knew the outcome.
How to Avoid Hindsight Bias
Investors should be careful when evaluating 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 or investments, not for their financial performance, but on a hunch.
One of the easiest ways to prevent hindsight bias is by keeping a journal or diary. This will create a record of the decision-making process, allowing you to revisit the reasons you came to certain conclusions. In large part, such a document will help ensure you are able to accurately reflect on a situation. These decision journals help detail when and how decisions were made.
This allows you to get a better idea of what you thought would happen at the time of making the decision. As well, weighing all information is important, including placing more weight on valuable information.
A decision journal can help allow for better decision-making in the future, as well as prevent second-guessing. Properly analyzing the results will help understand what went wrong (or right).
Professions, such as accounting, that require a lot of feedback are less prone to hindsight bias.
Hindsight bias can distract investors from an objective analysis of a company. Sticking to intrinsic valuation methods helps them make decisions 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.
To be effective at avoiding hindsight basis, an effective mathematical model is best used. This takes much of the guesswork and bias out of analyzing a company. In particular, using quantitative factors, such as financial statements and ratios. Still, intrinsic value has its limitations.
Notably, there's no universal intrinsic value calculation. There are many different models or valuation tools to use. As well, there are assumptions that must be plugged into any model, which can open itself to bias.
Quantitative and Qualitative Analysis
An intrinsic valuation will typically take into account qualitative factors such as a company’s business model, corporate governance, and target market. Quantitative factors such as financial statement analyses offer insights into whether the current market price is accurate or if the company 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 the weighted average cost of capital (WACC).
Examples of Hindsight Bias
Financial bubbles are always subject to substantial hindsight bias after they burst. Following the dot-com bubble in the late 1990s and the Great Recession of 2008, many pundits and analysts demonstrated clearly how events that seemed trivial at the time were actually harbingers of future financial trouble.
They were right, but other concurrent events reinforced the assumption that the boom times would never end. In fact, if a financial bubble was easy to spot as it occurred, it would likely have been avoided altogether.
The usual subjects of hindsight bias are not on that scale. Any number of investors who had the passing thought, sometime in the 1980s, that Bill Gates was a bright guy or that a Macintosh was a neat product may deeply regret not buying stock in Microsoft or Apple way back then when they "saw it coming." Actually, they may suffer from hindsight bias.
Executives are prone to hindsight bias (more so than others), according to economist Richard Thaler. This includes entrepreneurs, who are also inclined to hindsight bias. Notably, when asked whether their startup would become successful, over 75% of entrepreneurs of failed startups said yes. However, when asked again after their startup failed, only 58% said they believed their startup would be successful.
Business professionals will often use hindsight bias in decision making—assuming because a strategy worked previously it will continue to work. However, conditions are always changing and because something worked in the past doesn’t mean it’ll work again. Hindsight bias means that executives can make risky or poorly analyzed decisions.
Hindsight Bias FAQs
How Does Hindsight Bias Occur?
Hindsight basis happens when an event occurs, and based on past observances or beliefs, you knew it would happen. Hindsight bias is when some unforeseen event suddenly becomes foreseeable after the fact.
How to Prevent Hindsight Bias?
Preventing hindsight bias involves admitting you cannot predict the future and leaning on data to help make sound decisions (i.e. make decisions based on data, not feelings or emotions). This can be done by keeping detailed notes or a journal for the decision-making process. These notes may include factors for justification or any hunches or feelings.
Why Is Hindsight Bias Important in Business and Investing?
Hindsight bias can lead to errors in processing and analyzing information. These errors can lead to irrational decision-making, ultimately resulting in negative or poor investing or business decisions. These bad decisions can be costly in terms of money, missed opportunities, or misused resources.