Hindsight bias is a behavioral trait in many of us. It is a sense that you knew a particular incident would happen after it has happened. You feel that you had predicted the incident. It may not be accurate as you might have thought of different outcomes but once a particular outcome takes place, you tend to remember that one and forget the other possible outcomes.
This trait can lead to overconfidence and inaccurate estimation of events and their probabilities.
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Common examples of hindsight bias –
- If you see clouds getting thick and grey, you might think different things – ‘it might rain’, ‘it will rain’ or ‘the cloud cover will pass on’. But if it rains sometime later, you will believe that you knew it will rain.
- It is the finals of the IPL tournament and your favourite team is playing. If it is an equally contested match, you will think of different possibilities – ‘Your team wins’, ‘Your team loses’, ‘It can end up being a draw due to rains’. But if your team wins, you will feel that you predicted correctly that they will win.
- Similarly, you buy a stock and the price falls, you think that you just knew it that it would fall. On the other hand, if you make handsome profits, you will feel proud that you made such an awesome decision.
- And everyone knew that who will win the elections 🙂
Impact of Hindsight Bias on your Investments
Hindsight bias can lead negative effects on our investment behaviour and overall personal finances –
It can lead to overconfidence in our investment skills. If we pick some stocks or purchase some mutual fund schemes and they perform well, we believe that we have excellent investment skills. We only remember the instances when we were right and overlook the times when we were wrong. It might be that the factors that allowed us to predict correctly made the decision easy or obvious. This might lead to irrational and risky investment behaviour.
Look only for expected outcomes –
We tend to look for expected outcomes in any decision/action we take. We tend to remember only the big unexpected events. This results in not planning for the unexpected events. If we do not remember smaller events that affected our portfolio, we may not be managing the portfolio in the best manner. It is not possible to think of all possible outcomes but we have to be ready for unexpected outcomes. Believing that unpredictability is the norm will not have too many nasty surprises.
Mistaken analysis –
We tend to use memory rather than data and other factors to evaluate past decisions. This is a trap. It clouds our decision making. We remember the times our predictions were right and ignore the wrong ones. This can lead to irrational decisions regarding our finances.
Another mistake form of decision making is that if an event happens, we tend to look back and look for signs and pointers that proved that the event will happen. In hindsight, this might be easy, but at that time, there were many other factors and signs which would have made it difficult to predict.
How can we avoid hindsight bias –
Learn from the past –
We should learn from past mistakes – our mistakes made in the investment world. For example, when the technology bubble was busted in 1998, a lot of people said, ‘I knew it’ but very few of them had forecasted it. It is not easy to predict different scenarios. But we can learn from past performance of investment assets, market behaviour and our behaviour and decision making. Rather than focusing only on the right decisions, one should objectively evaluate all investment decisions – right and wrong.
Be aware of the influence of hindsight bias –
A majority of us have a hindsight bias. It is best to acknowledge it and then work around it so that we do not make wrong investment decisions. For example, if you have decided to buy a stock, do not look for reports and news articles that support your decision (this is confirmation bias). Search for reasons or news items that go into the decision. This will help in a more holistic investment decision.
Plan for the unexpected –
Expect the unexpected. Hope for the best but plan for the worst. We should hedge against negative events. It is a good idea to diversify the investment portfolio so that it is protected against unexpected negative outcomes. Focus on proper Asset Allocation.
Avoid being overconfident –
We tend to become overconfident when we feel that we have predicted events correctly. We follow the same pattern of decision making and somewhere down the line, we lose money. It is better to have a realistic view of our strengths and limitations. Look for performance indicators while making investment decisions. This helps in managing risk better and building a suitable investment portfolio.
Decide rationally –
Do your research thoroughly, understand the pros and cons of all investment decisions and actions and then choose the most appropriate one in your current situation rather than being swayed by past predictions.
Hindsight bias is a behavioral trait that can lead to problems in your investment portfolio. No one can be right all the time or wrong all the time. Objective evaluation is the best way to avoid such biases and make rational investment decisions.
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