Modules for Investors
Investment Biases - Part 2
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Hindsight bias: should have done that!
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Consider the 2008 financial crisis or the dotcom bubble of the late 1990s. If you talk to many people now, they may state that all the signs were there and everyone knew it was coming. However, if you examine the history, you learn that analysts or investment professionals who were screaming that there was a problem at the time weren’t listened to, in fact, they were laughed at and investors largely ignored their warnings.
Investors feel pressure to time their purchases of stocks perfectly 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 he or she saw it coming.
Hindsight bias is a mistaken belief that outcomes were (and are) predictable. Investment analysts are particularly susceptible to this bias. Hindsight bias is demonstrated by those who remember their forecasts that turned out to be accurate and forget those that were inaccurate. This can lead to excessive risk-taking due to an irrationally high assessment of one’s ability to correctly predict outcomes.
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.
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 not for their financial performance but on a hunch.
Hindsight Bias and Intrinsic Valuation
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.
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 analysis offer insights into whether the current market price is accurate or if the company is overvalued or undervalued.
How to Avoid Hindsight Bias
In the other behavioral finance articles, we’ve talked about the need to keep an investment diary. We need to map the outcomes of our decisions and the reasons behind those decisions to learn from both our wins and our losses. An investment diary also helps mitigate against the bias of self-deception, which again limits our ability to learn.
Hindsight bias prevents us from recognizing and learning from our mistakes. We talk about it as a limit to our learning because we tend to believe after the fact that we knew about something all along.
So, how do we guard against this bias? An investment diary, comparing outcomes to the reasoning behind our investment decisions, is a good way to keep this hindsight bias in check.
Explanations of Hindsight Bias
So what exactly causes this bias to happen? Researchers suggest that three key variables interact to contribute to this tendency to see things as more predictable than they really are.
- Cognitive: People tend to distort or even misremember their earlier predictions about an event. It may be easier to recall information that is consistent with their current knowledge.
- Metacognitive: When we can easily understand how or why an event happened, that event can seem like it was easily foreseeable.
- Motivational: People like to think of the world as a predictable place. Believing an outcome was "inevitable" can be comforting for some people.
When all three of these factors occur readily in a situation, the hindsight bias is more likely to occur.
When a movie reaches its end and we discover who the killer really was, we might look back on our memory of the film and misremember our initial impressions of the guilty character. We might also look at all the situations and secondary characters and believe that given these variables, it was clear what was going to happen. You might walk away from the film thinking that you knew it all along, but the reality is that you probably didn't.
Such risks might be financial, such as placing too much of your nest egg in a risky stock portfolio. They might also be emotional, such as investing too much of yourself in a bad relationship.
Now that you know about Hindsight bias, it’s only logical that we move on to the next big topic - Overconfidence bias: I must be correct!. To discover the answer, head to the next chapter.
A Quick Recap
- Hindsight bias is a psychological phenomenon in which one becomes convinced that one accurately predicted an event before it occurred.
- It causes overconfidence in one's ability to predict other future events.
- 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.
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