A keen-eyed Twitter regular recently pulled us up on one of our tweets asking what bias we were referring to. Good question and with ‘hindsight’ we should have made it clear…
There are so many investment-impacting behavioural biases, we could probably identify at least one for nearly every letter in the alphabet (I feel a blog series coming on...). Some biases are more significant (or harmful) than others, today we’ll look at Hindsight and will return to look at others in future blogs.
What is it? “the ability to understand an event or situation only after it has happened” is the succinct Cambridge Dictionary definition. “Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman credits Baruch Fischhoff for demonstrating hindsight bias – the “I knew it all along” effect – when he was still a student. Kahneman describes hindsight bias as a “robust cognitive illusion” that causes us to believe our memory is correct when it is not. For example, say you expected a candidate to lose, but she ended up winning. When asked afterward how strongly you predicted the actual outcome, you’re likely to recall giving it higher odds than you originally did. This seems like something straight out of a science fiction novel, but it really does happen!
When is it helpful? Similar to blind spot bias (we’ll say more on this in a future blog) hindsight bias helps us assume a more comforting, upbeat outlook in life. As “Why Smart People Make Big Money Mistakes” authors Gary Belsky and Thomas Gilovich describe it, “We humans have developed sneaky habits to look back on ourselves in pride.” Sometimes, this causes no harm, and may even help us move past prior setbacks.
When is it harmful? Hindsight bias is hazardous to investors, since your best financial decisions come from realistic assessments of market risks and rewards. As Kahneman explains, hindsight bias “leads observers to assess the quality of a decision not by whether the process was sound but by whether its outcome was good or bad.” If a high-risk investment happens to outperform, but you conveniently forget how risky it truly was, you may load up on too much of it and not be so lucky moving forward. On the flip side, you may too quickly abandon an underperforming holding, deceiving yourself into dismissing it as a bad bet to begin with.
Back to our tweet: Nobel laureate Richard Thaler, in his book Misbehaving, drew an analogy from business: “I found the concept of hindsight bias fascinating, and incredibly important to management. One of the toughest problems a CEO faces is convincing managers that they should take on risky projects if the expected gains are high enough. Their managers worry, for good reason, that if the project works out badly, the manager who championed the project will be blamed whether or not the decision was a good one at the time. Hindsight bias greatly exacerbates this problem, because the CEO will wrongly think that whatever was the cause of the failure, it should have been anticipated in advance. And, with the benefit of hindsight, he always knew this project was a poor risk. What makes the bias particularly pernicious is that we all recognize this bias in others but not in ourselves.” The emphasis is ours.
We can help you eliminate hindsight bias from your investments, if you want to know how just ask.
Look for our next behavioural biases piece soon.