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 to 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 at an event and believes they predicted the outcome, even if they failed to act on that "prediction." Unfortunately, this leads people to think that 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. Hindsight bias is caused by:
- Memory distortion
The bias occurs when we remember something we believe we predicted and view it at the present time as an inevitable event we knew would happen.
Investors often feel pressure to perfectly time buying or selling stocks 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 them to make poor decisions in the future unknowingly. 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 issues tied to hindsight bias.
What Causes Hindsight Bias?
Hindsight bias occurs when new information comes to light about an 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, people tend to exaggerate the extent of their prediction of the event. 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. Hindsight bias might not be tied to only the ineffective processing of information but be rooted in adaptive learning.
People 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 desire a positive view of ourselves and therefore try to make sense of it by creating 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 can predict future results can lead to overconfidence, and overconfidence can lead to choosing stocks or investments on a hunch, not for financial performance or value. Here are some tips to help you avoid this bias:
- Brainstorm alternative outcomes: Think about other things that might have happened in the situation you're considering. Because circumstances change, this can help you in the future if you encounter similar situations.
- Keep 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 can accurately reflect on a situation. These decision journals help detail when and how decisions were made. This allows you to understand better what you thought would happen when making the decision. Additionally, weighing all information is essential, including placing more weight on valuable information.
- Review your journal entries: A decision journal can help allow for better decision-making in the future, as well as prevent second-guessing. Analyzing the results of your decisions will help you understand what went right or wrong and help you identify other solutions or opportunities.
Professions that require a lot of feedback, such as accounting, 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 decide on data-driven factors, not personal ones. Intrinsic value refers to the perception of a stock’s true value based on all aspects of the business—it may not coincide with an investment's current market value.
To avoid hindsight basis, it's best to use a mathematical model. This takes much of the guesswork and bias out of analyzing a company. Quantitative factors, such as financial statements and ratios, are much more indicative of performance than opinions based on personal experience. Quantitative aspects such as financial statement analyses offer insights into whether the current market price is accurate or the company is overvalued or undervalued.
An intrinsic valuation will also take into account qualitative factors such as a company’s business model, corporate governance, and target market.
Notably, there's no universal intrinsic value calculation. There are many different models or valuation tools to use. Some assumptions must be plugged into any model, which can open that model up to bias.
Examples of Hindsight Bias
Financial bubbles are always subject to substantial hindsight bias after they burst. For example, following the dot-com bubble in the late 1990s and the Great Recession of 2008, many pundits and analysts demonstrated their precise knowledge of how events that seemed trivial at the time were 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 were easy to spot as it occurred, it would likely have been avoided altogether.
The 80s Computer Debut
The usual subjects of hindsight bias are not on that scale. For instance, many investors in the 80s were interested in technology, industrials, and materials, but computer software and hardware were only making their debut—many didn't see the industry amounting to anything. As a result, there are quite possibly millions of investors from that time who deeply regret not buying stock in Microsoft or Apple when they "saw it coming."
Professionals and Executives
Business professionals will often use hindsight bias in decision making—assuming because a strategy worked previously, it will continue to work. Unfortunately, hindsight bias means executives can and might make risky or poorly analyzed decisions. Anyone that's heard the old sayings, "It worked before, it should work again" or "this is how we've always done it" at work has experienced an example of hindsight bias in the professional space.
What Causes Hindsight Bias?
Hindsight bias is caused by memory distortion, foreseeability, and inevitability, where we remember something we believe we predicted and view it at the present time as an inevitable event we knew would happen.
Why Is Hindsight Bias Important in Psychology?
It is important because it clouds our ability to learn from experiences and make future decisions.
What Is the Difference Between Hindsight Bias and Confirmation Bias?
Confirmation bias is when you look for information to support your beliefs, while hindsight bias is the belief that you predicted an event in the past.
The Bottom Line
Hindsight bias is a natural human response to past events in which we believe we knew the event would happen. We then associate that belief with new events, even when circumstances that can affect the outcome are different. It can be difficult to identify when you're affected by hindsight bias, but using tools to analyze events to find solutions can keep you from falling for this psychological trick your mind plays on you.
Keeping and revisiting journals, discussing the event with peers, and analyzing the surrounding circumstances while imagining alternate outcomes are ways you can avoid making decisions when under the influence of hindsight bias.