Did you expect a market crash in 2020?
How bad did you think the market crash would be?
How quickly did you think the market would recover?
Are you sure that’s what you thought?
Our minds play tricks on us. The worst part is knowing about it doesn’t help. Hindsight bias is one such trick that messes with our memories in a couple of different ways.
- We tend to look back on our past predictions as being more accurate than they were.
- We tend to look back on events as being more foreseeable than they were at the time.
Richards Heuer, in Psychology of Intelligence Analysis, related a couple of examples.
An experiment was created to test a subject’s memory of past estimates. Test subjects were asked to estimate the likelihood of different outcomes to President Nixon’s trips to Peking and Moscow in 1972. Each subject assessed fifteen outcomes for each trip and attached a probability to each outcome. At various times after the trip, the test subjects were asked to recall their prior answers and whether the event occurred or not.
Roughly three to six months after the event is all it took for 84% of the subjects to exhibit hindsight bias. That is, they misremembered giving higher estimates than they actually gave to events that did occur and lower estimates to events that did not occur. In other words, they believed they were more accurate at predicting outcomes than they actually were.
Time became the determining factor. Test subjects had no problem answering correctly after only two weeks. That it only took a few months for their memory to fade, shows how quickly hindsight bias reshapes memories.
Another experiment tested whether well knowing the outcome affected the subject’s estimates of the outcome occurring. Test subjects were broken into five groups. A short summary of events between the British and Gurkhas in 1814 was created, along with four possible outcomes.
The first group was given the summary, along with the four outcomes but no hint of which outcome actually happened. The other four groups were also given the summary and the four possible outcomes. Only each group received a one-sentence hint that a different outcome actually occurred. Then each group was asked to objectively estimate the probability of each outcome happening.
The results should be obvious.
The four groups that were told the “outcome” in advance gave a higher estimate to that outcome occurring — by almost double. Not only that, being told the outcome affected how they viewed the data. They put more weight on information that backed up the outcome they were told. In other words, knowing the outcome makes it seem more predictable because it’s harder to look at all the information objectively.
So how much trouble can the hindsight bias cause?
Let’s say you believe you picked last year’s Superbowl winner, even though we all know you didn’t. Nobody cares, frankly. Stop bringing it up already. The boastful “I knew it all along…” statements mistakenly boost your confidence, annoy your friends, and that’s about it.
Hindsight bias has developed over millennia to protect our ego. The confidence boost can be a good thing, but in certain situations, it can lead to costly decisions.
You’re confident. Maybe too confident. Because your mind tricked you into thinking you’re better at predicting past market moves than you really are.
So you put your newfound skill to the test. You bet on the direction of stocks. The worst-case scenario likely starts off better than expected. It works…at first. You make money early. Your inflated ego grows. You trade more often, more aggressively with bigger, more concentrated bets. You neglect important information.
And you start to lose…a lot. Because that’s what happens when you believe you have a skill that doesn’t exist.
The second issue is that hindsight bias compounds the first issue. You already think you can predict things better than you can. Now you also believe past events were easily foreseeable in advance?
Hindsight bias makes investing seem easy. If past bubbles and crashes look obvious in hindsight, it should be easy to spot in advance. The same goes for picking stocks of great companies. Of course, Amazon was a great investment. And if past market turns seem obvious, market timing must be easy.
Of course, predicting past events was not obvious nor is investing easy. It just looks that way, after the fact, because we only see one outcome. History deprives us of the noise, uncertainty, and irrelevant information we would have dealt with at the moment. All we see is the signal. That’s why past events appear clear and obvious in hindsight. It makes it harder to imagine that other possible outcomes existed but didn’t occur. Which makes it harder to imagine our thought process in that situation.
So hindsight bias might protect your ego, but the second-order effect has a high potential of losing money. Now, how do we avoid it?
The first thing we can do is expect to be wrong sometimes. The nature of uncertainty means, not every investment will work out as expected. And that’s okay. One way to do this is to write a premortem. It’s a postmortem, written in advance, but assume the investment was a complete disaster. Understanding the consequences of being wrong, knowing the downsides of an investment, should keep your ego in check and avoid bigger losses.
Next, don’t make hasty decisions. A day or two to think about an investment might be enough to recognize if you’re too optimistic about it or not. The added time might also stoke your curiosity to research more.
Last, create an audit trail. Since you can’t rely on your memory to keep past decisions straight, make a record of everything. Keep track of every investment and transaction, the information you researched, why you bought it, how much you expected to make, why you sold it, and how much you made or lost. Write the pros, the cons, any concerns, worries, and why. You can do the same for investments you rejected. Then review it regularly. At worst, the review keeps you humble.
Writing it down won’t cure your hindsight bias, but it offers a chance to thoroughly examine past decisions and improve on them. It’s not a perfect solution but it’s better than letting your mind trick you into thinking your past decisions turned out better than they actually did.
- Marks Memo: Time for Thinking (pdf) – Oaktree
- Knowing When to Ignore the Numbers – Klement on Investing
- The Cautionary Tale of Equity Research – Net Interest
- Discounting, Death, and the Demand for Growth Stocks – Verdad
- Why Markets Don’t Seem to Care If the Economy Stinks – B. Ritholtz
- What Peter Lynch Might Say To New Investors – ValIdea
- Public to Private Equity in the United States: A Long-Term Look (pdf) – M. Mauboussin
- The Collectors Who Spend Thousands on Rare Hot Wheels – The Hustle
- How the Pandemic Defeated America – The Atlantic