There are several cognitive biases that affect our ability to think clearly about financial investments. One such bias is called the hindsight bias. Over the years, the effect of hindsight bias on the value of investor portfolios has been significant. This is the reason that we will have a closer look at what this bias means and how it affects investor decisions in this article.
What is Hindsight Bias?
The crux of hindsight bias is often caught in sayings such as hindsight is always 20/20. The basic meaning of this bias is that people with hindsight bias look at events that have occurred and believe that it was very easy to predict the course of these events when, in reality, it was not. For instance, many investors today look at Apple stock and believe that it was an obvious choice two decades ago! However, that is not the case. The rise of Apple was not predictable at all, and it was quite possible that Apple would not have grown into the company that it has become today but would have instead gone bankrupt.
The problem is that investors with hindsight bias notice patterns in past events. Then, they try to extrapolate the same patterns and apply them in the present or future events. However, as mentioned above, the outcomes are not predictable. Hence, even if an investor found a company that has an identical financial and business value proposition that Apple had two decades ago, the odds are that the company would still not grow to become Apple.
It is important for investors to understand that while talking about investments, hindsight is almost never perfect. Expecting something to happen again just because it happened in the past is a lousy reason to make an investment decision. This is because there is seldom any pattern or predictability in past events except when we look at them from the lens of the future.
How Hindsight Bias Affects Decision Making?
Hindsight bias can have a significant impact on the decision making of an investor. Following are some examples of how hindsight bias distorts thinking.
If a new investor makes the first few investments and they turn out to be profitable, then the investor starts assuming that this is because of some special skill that they have. This opinion is largely derived from their success. However, they start wrongly assuming that all the investments that they make in the future will also be as successful as the investments that they made in the past. This is when they start taking excessive risks because of the false belief in their ability. This is also where the hindsight bias starts causing harm. Riskier investments are prone to cause financial loss today or tomorrow, and people with hindsight bias may not be able to foresee the risks or even take corrective actions.
Hindsight bias makes investors make wrong asset allocation decisions. When investors make such decisions, they often focus solely on the past price of these assets and the growth that may have occurred in the previous years. They falsely attribute this growth to the financial acumen of the management team and invest funds. As a result, when investments do not finally meet their expectations, they begin to falsely blame the investment company without realizing that ups and downs are part of the investment process.
Investors who suffer from hindsight bias tend to make several predictions. Sometimes, they make hundreds of predictions, and one or two of them do turn out to be true. This is where they start believing that they have some special skill. They talk to their acquaintances about the same one or two predictions that have gone right and forget about the rest of the predictions. If an investor were to actually put money on each of their predictions, they would lose a significant chunk of their money. However, they tend to focus only on the successful ones.
How Can Hindsight Bias be Avoided?
Hindsight bias can be a bit tricky to avoid. The mere knowledge about the existence of a bias does not make a person immune to it. However, it gives an individual a better chance to be prepared. Some more tips and tricks can be used in order to avoid such biases.
It is helpful if investors make mock forecasts and note down all the forecasts that they have made over a period of time. This will help them realize how many of their forecasts actually go wrong, and the fact that some go right is nothing more than a random chance!
Also, it is helpful for investors to forcefully try to imagine alternate and even opposite scenarios to what they are predicting. This helps them understand that the future is not so predictable, and a variety of outcomes are possible. If they can manage with each of the outcomes, only then they should go ahead and make an investment.
The fact of the matter is that hindsight is not all that bad. It helps humans repeat the things that have been rewarding in the past and avoid the ones which have been painful. However, it is important to use hindsight only as a guiding light. If anyone thinks that hindsight is absolutely perfect and that they can predict markets with absolute certainty, then they are bound to make mistakes in the long run.
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