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Belief Perseverance Bias #6: Hindsight Bias
Hindsight is a wonderful thing.
—David Beckham
Bias Description
Bias Name: Hindsight bias
Bias Type: Cognitive
Subtype: Belief perseverance
General Description
Described in simple terms, hindsight bias is the impulse that insists: “I knew it all along!” This is perhaps the most pronounced version of belief perseverance biases. Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable—even if it wasn't. This behavior is precipitated by the fact that actual outcomes are more readily grasped by people's minds than the infinite array of outcomes that could have but didn't materialize. Therefore, people tend to overestimate the accuracy of their own predictions. This is not to say, obviously, that people cannot make accurate predictions, but merely that people may believe that they made an accurate prediction in hindsight. Hindsight bias has been demonstrated in experiments involving investing—a few of which will be examined shortly—as well as in other diverse settings, ranging from politics to medicine. Unpredictable developments bother people, since it's always embarrassing to be caught off guard. Also, people tend to remember their own predictions of the future as more accurate than they actually were because they are biased by having knowledge of what actually happened. To alleviate the discomfort associated with the unexpected, people tend to view things that have already happened as being relatively inevitable and predictable. This view is often caused by the reconstructive nature of memory. When people look back, they do not have perfect memory; they tend to “fill in the gaps” with what they prefer to believe. In doing so, people may prevent themselves from learning from the past.
Example of Hindsight Bias
Many people have observed hindsight bias in the investment realm. They watch people fool themselves into thinking that they could have predicted the outcome of some financial gamble, but they achieve such crystal-clear insight only after the fact. Perhaps the most obvious example recalls the prevailing response by investors to the behavior of the U.S. stock market between 1998 and 2003. In 1998 and 1999, virtually nobody viewed the soaring market indexes as symptomatic of a short-lived “bubble” (or if they did harbor such misgivings, investors did not act on them). Above-average returns were the norm, though even a casual glance at historical business-cycle trends should have foretold that, eventually, the 1990s bull market had to recede. Still, sadly, even some of the most sophisticated investors succumbed to the fantasy: “It's different this time!” Similarly, in 2006, when the first edition of this book was published, it was inconceivable to most people that housing could be an unsafe “investment” and that a financial crisis of epic proportions was in the making. Now, in 2021, most people concede the reality of the housing and credit bubbles, the Internet stock bubble, and the subsequent meltdown in a distant memory or have forgotten altogether. In fact, chatting with most investors today, you'll get the impression that they expected the collapse of housing prices. The collapse of late 2000s prosperity was “clearly in the cards,” or they comment: “Wasn't it obvious that we were in a bubble?” Giving in to hindsight bias can be very destructive because it leads investors to believe that they have better predictive powers than they actually do. Relying on these “powers” can invite poor decision making in the future.
Implications for Investors
Perhaps the hindsight bias's biggest implication for investors is that it gives investors a false sense of security when making investment decisions. This can manifest itself in excessive risk-taking behavior and place people's portfolios at risk. Box 8.1 reviews some common behaviors, rooted in hindsight bias that can cause investment mistakes.
Am I Subject to Hindsight Bias?
These questions are designed to detect cognitive errors caused by hindsight bias. To complete the test, select the answer choice that best characterizes your response to each item.
Hindsight Bias Test
Question 1: Suppose you make an investment, and it increases in value. Further suppose, though, that your reasons for purchasing the investment did not rely on the forces underlying its growth. How might you naturally react?
- I do not concern myself with the reasons an investment does well. If it performs well, it means I did a good job as an investor, and doing well makes me more confident about the next investment I make.
- Even though the stock went up, I'm concerned that the factors I thought were important didn't end up impacting its performance. In cases like this, I usually try to revisit the reasons that I bought the stock, and I also try to understand why it succeeded. Overall, I think I'd be more cautious the next time around.
Question 2: Suppose you make an investment and it goes down. What is your natural reaction to this situation?
- Generally, I don't fault myself—if an investment doesn't work out, this may simply be due to bad luck. I'll sell the stock and move on, rather than pursuing the details of what went wrong.
- I would want to investigate and determine why my investment failed. In fact, I'm very interested in finding out what went wrong. I put a lot of emphasis on the reasons behind my investment decisions, so I need to be aware of the reasons behind my investment's performance.
Question 3: Suppose you are investigating a money manager for inclusion in your portfolio. Your advisor suggests a large-cap value manager for you. What is your natural approach to examining the manager's performance?
- I tend to look primarily at a manager's track record, comparing his or her performance to some relevant benchmark. I don't concern myself with the strategy that the manager employs. The results that a manager achieves are most important. If returns impress me, then I will select that manager; if I see a mediocre history, I'll pass.
- I look at the returns, which are important, but I also look at the manager's strategy and try to determine what the manager was doing during the time frame I'm examining. In the case of the value manager, I will look, for example, at 2002—the manager was probably down, but by how much? Which companies did the manager invest in at the time? Evidence of a sound strategy makes me more likely to select this money manager.
Test Results Analysis
Questions 1, 2, and 3: Hindsight bias is a difficult bias to measure because people are rarely aware that they harbor it. So, few are likely to take a test like this and effectively respond: “Yes, I am susceptible to ‘I-knew-it-all-along’ behavior.” Even people with reason to believe, objectively, that they might suffer from hindsight bias are unlikely to admit it to themselves. So, this diagnostic test looks for clues that might indicate symptoms of potential hindsight bias. For each item, respondents identifying with the rationale in “a” should be aware that they exhibit such symptoms and that they may suffer from hindsight bias.
Investment Advice
In order to overcome hindsight bias, it is necessary, as with most biases, for the investors to understand and admit their susceptibility. Here are some thoughts to help you better deal with hindsight bias:
“Rewriting history”—predicting gains. When an investor overestimates the degree to which some positive investment outcome was foreseeable, this may be due to hindsight bias. Consider the collapse of the credit bubble in the 2008–2009 period, when risks fueled by excessive credit cost stockholders billions. Many investors used rationales like “I knew that stock was going to go up! I told you so,” which is a cautionary tale that can highlight the pitfalls of overestimating one's own predictive powers.
“Rewriting history”—predicting losses. Investors need to recognize that many people prefer to block recollections of poor investment decisions. Understanding why investments go awry, however, is critical to obtaining insight into markets and, ultimately, to finding investment success. Investors need to carefully examine their investment decisions, both good and bad. Encourage self-examination. This will help eliminate repeats of past investment mistakes.
Unduly criticizing money managers for poor performance. Investors need to understand that markets move in cycles and that, at certain times, an investment manager will underperform in his or her class, relative to other asset classes. Investors should understand that a good manager adheres to a consistent, valid style, through good times and bad. A manager is hired to do a job, and that job is to implement a defined investment strategy. Education is critical here. Just because many growth managers underperformed in the early 2000's, when values of many stocks were in a downward cycle, does not mean that growth managers are categorically unskilled. A similar case can be made for managers of “quality” stocks (safe, large-capitalization companies).
Unduly praising a money manager for good performance. Using the same line of reasoning, investors should guard against becoming too giddy over the prospects offered by managers who happen to be in the right asset class at the right time. There are plenty of investment managers who benefit circumstantially from market cycles and still do not meet benchmarks. These are the managers to avoid. Again, education is critical; once investors understand the role that a manager plays in determining fund performance, hindsight bias can be curtailed.