Hindsight bias

Hindsight bias is a psychological trait which leads to investors overestimating their predictive abilities. Many pundits have claimed that stock market meltdowns like the dotcom bubble and global financial crisis of 2008 could have been predicated based on stock valuations. But the magnitude of these corrections was largely unexpected; if many people knew beforehand that stock prices would crash, then crash would not have been so severe, which means that the explanation of these crises had the benefit of hindsight.

Examples of benefits of hindsight

  • Your favourite team is playing in the IPL final, needing 20 runs to win in the final over. Your team scores the required runs and wins the match. If you always knew that your team will win the match then you may be exhibiting hindsight bias. People who have played cricket know that scoring 20 runs in one over against a top bowler is a very difficult task. The batsmen would have simply taken their chances and got lucky. You are misinterpreting chance or luck with your predictive powers.
  • Elections have taken place and opinion polls suggest a close contest. When the results are declared and the party you supported wins by a big margin. If you say that, you always knew that this party would win by a big margin then it is a case of hindsight. What if the party lost by a close margin?
  • You buy a stock. According to random walk theory of stock prices, the price can either rise or fall in the short term. The stock price rose and you made a handsome profit. Your profit was simply due to luck, not due to your ability to make great investment decisions.

In all the three examples, the results were favourable for you. But just because the results were what you wanted does not make you a cricket, political or investment expert. It was a matter of chance and you were lucky. Restricting ourselves to the domain of investments, you must realize that there is an element of unpredictability or randomness in price movements in general and price outcomes of different events. Beware of people you always claim that they knew what would happen. We are not saying that they are consciously lying or they are frauds; they have the behavioural trait of hindsight bias.

People explain events post facto using the benefits of hindsight, but this bias leads people to believe that such events are more predictable than they really are. It can lead to the following negative consequences:-

  • Over-confidence: Over-confidence in our investment knowledge or abilities can lead us to make risky investments or investments without doing the necessary homework.
  • Not be ready for unexpected outcomes: Know what is important and what is not. You need to understand what will make your financial goals successful and filter out the unimportant information.
  • Do not track your portfolio on a daily basis: Investors with hindsight bias tend to base their decisions on major events they have experienced. However, they may not be prepared for smaller events which also have an effect on investment returns. In investments you should be prepared for unexpected outcomes and plan accordingly.
  • Relying on memory instead of logical analysis: People with hindsight bias rely on their judgement based on past experience. They rely more on their memory than rational, systematic and thorough analysis. This leads to wrong investment decision.

How to avoid hindsight bias

  • Be prepared for all outcomes including unpleasant ones: There is an old saying, “Hope for the best, but plan for the worst”. Do not expect that things will always go according to plan. Know your risk appetite and always invest according to it.
  • Asset Allocation: People with hindsight bias are likely not to give importance to asset allocation because they believe that they are always right. Asset allocation on the other hand, helps you plan for risks and tries to reduce the impact of risk events on your portfolio returns.
  • Increase your investment knowledge and apply it: Understand risk profiles of different asset classes / sub classes, make a financial plan and investment according to your financial goals, instead basing your investment decisions on past events.

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