Hindsight Bias

This week we take a look at hindsight bias. The hindsight bias is also referred to as creeping determinism, and the knew-it-all-along effect.

The hindsight bias refers to a person’s belief and tendency of having predicted the outcome of an event when, in reality, there was no sure way of knowing the outcome. This is a fairly common phenomenon that most people tend to take up at some point of time in their lives―some, more often than others. There are varied nuances to this occurrence and the effect of harboring and encouraging this tendency can lead to limitations in any decision-making process.

The simplest way to explain the occurrence of this phenomenon is with the term ‘I knew it’. Have you ever had an experience where you (or anyone else) has looked upon the outcome of something and said, ‘I knew it’?

A great example of the “I knew it” bias is shown below.

“All though we gave him all of that money and support, I always had my doubts that Jim could build his own helicopter.”

Source: Towergate Insurance

So what implications does hindsight bias have for investors?

According to Michael M. Pompian, author of Behavioral Finance and Wealth Management “the effects of Hindsight Bias can have harmful effects for investors as seen below.

HINDSIGHT BIAS: BEHAVIORS THAT CAN CAUSE INVESTMENT MISTAKES

1. When an investment appreciates, hindsight-biased investors tend to rewrite their own memories to portray the positive developments as if they were predictable. Over time, this rationale can inspire excessive risk taking because hindsight-biased investors begin to believe that they have superior predictive powers, when, in fact, they do not. The bursting of the technology bubble is an example of this bias in action.
2. Hindsight-biased investors also “rewrite history” when they fare poorly and block out recollections of prior, incorrect forecasts in order to alleviate embarrassment. This form of self-deception, in some ways similar to cognitive dissonance, prevents investors from learning from their mistakes. A clear example of this bias took place in the early 1980s, when energy stocks generated over 20 percent of S&P 500 returns, and lots of investors were caught up in the boom. By the 1990s, though, the energy bubble subsided, and many stockholders lost money. Most now prefer, in hindsight, to not recognize that the speculative frenzy clouded their judgments.
3. Hindsight-biased investors can unduly fault their money managers when funds perform poorly. Looking back at what has occurred in securities markets, these investors perceive every development as inevitable. How, then, could a worthwhile manager be caught by surprise? In fact, even top-quartile managers who implement their strategies correctly may not succeed in every market cycle. Managers of small-cap value funds in the late 1990s, for example, drew a lot of criticism. However, these people weren’t poor managers; their style was simply out of favor at the time.
4. Conversely, hindsight bias can cause investors to unduly praise their money managers when funds perform well. The clarity of hindsight obscures the possibility that a manager’s strategy might simply have benefited from good timing or good fortune. Consider the wisdom attributed to managers of aggressive-growth tech funds in the late 1990s.