Hindsight Bias - Meaning, Examples, Causes & How to Avoid Hindsight Bias

Piyush invested in a stock that crashed, to which he responded that he always knew that the stock would crash. And now he does not invest in similar stocks as he is overconfident about his last prediction. Similarly, Riya had invested in mutual funds that gave an average growth over 5 years, to which she responded that she always knew this would be the growth percentage.

Note: The above example is for illustrative purpose only

What Piyush and Riya are facing is called Hindsight Bias. Let us learn the meaning of hindsight bias, the effect of hindsight bias in decision making and how to avoid it.

What is Hindsight Bias?

Hindsight Bias is a psychological phenomenon that makes people believe after an event has occurred that, they had accurately predicted it. This feeling can be described as the ‘knew-it-all-along’ effect. Investors are constantly under extreme pressure to time the markets, and when there is a setback, they regret not acting sooner. This regret makes them believe that they always knew this would happen. While the reality is that the outcome is one of the many ideas they would have thought of. This is harmful because it can lead people to believe they can predict events accurately and instil overconfidence. This eventually can leadto bad decision-making in the future.

There are three levels of hindsight bias:

Memory Distortion - Said It

Predictability - Knew It

Inevitability - Meant to be

After the event occurs, the investor analyses and recalls memories of events that show the signs of the outcome. They believe they predicted the outcome and always knew it was inevitable. This is memory distortion, predictability and inevitability.

What causes Hindsight Bias?

When the stock Piyush invested in crashed, it was a piece of new information that he received. He returned to the events before the crash, selectively picked a few that confirmed the outcome, and believed that he always knew this was coming. Now this bias barred Piyush from reviewing the outcome carefully with all its possibilities.

After knowing the outcome of an event, attaching your belief to the probability of it happening is easy. Say the weather in the city can be sunny or rainy, and after it rains,many people will say they witnessed dark clouds or the weather was gloomy, and they knew it was going to rain. A bias of this sort is rooted in overconfidence and anchoring. Believing that you know it all and using the knowledge of the outcome as an anchor to attach previous judgements is what causes hindsight bias.

Additional Read:Advantages of SIP in Volatile Market

How to Overcome Hindsight Bias?

Hindsight bias is studied in behavioural economics as it is one of the reasons investors fail. Investing right is a game of numbers and analysis, not feeling or predicting. So how can an investor overcome this bias to take rational decisions while investing?

The first thing to do is look at an outcome and consider all the other possibilities. So say, the stock Piyush invested in crashed because of an XYZ reason; however, the action now is to understand what else could have happened, is ABC a possibility, and if ABC is a possibility, would the outcome change?

The next thing is to document all of this. This will form data for better decision-making. This journal will allow you to reflect on your decision-making process. The journal could be in the below-mentioned format:

This decision journal will help you revisit why a certain decision was taken. If you let hindsight bias take over, you will think you knew this was coming attaching this belief to some selective information, missing out on a 360-degree view of the problem. And all future decisions will be based on this bias.

Maintaining the journal is one thing; revisiting it to review the entries and drawing your decisions based on it is another. Avoid second-guessing and visit the journal entries to analyse what-if scenarios for better decision-making.

For investors, an additional check would be to look at the intrinsic valuation of the company/firm they are investing in. Financial statements, ratio analysis, etc., are better factors to base predictions rather than personal feelings and intuitions. These factors allow the investor to gauge if the market price of the investment is justified. They can understand if the company/firm is overvalued or undervalued.

Example of Hindsight Bias

History has been witness to many examples of hindsight bias. The most popular ones are:

The dot-com boom: In the late 1990s, stocks of US technology companies saw a significant rise, only to fall miserably later. Now many analysts will say they saw the fall coming, and many investors regret not making the best of the boom when they saw it coming. Both of these are hindsight biases.

The Great Recession 2008: The decline in national economies globally between the period 2007 to 2009 was claimed by many as the ‘knew-it-all-along’ effect. They claim to know the minute things that triggered the downfall when many factors contributed to it.

What Is The Difference Between Hindsight Bias And Confirmation Bias?

Confirmation bias is when you hold a particular belief and find information to support it. Hindsight bias is when you claim that you can predict future events accurately after their occurrence. Confirmation bias is processing new information with the filter of previous beliefs. Hindsight bias is processing further information by attaching previous information suggesting the outcome and claiming to know it all along.

Example:

Confirmation bias:

Belief: Ayurveda is better than allopathy Google Search words: side effects of allopathy or best properties of ayurveda

Hindsight Bias: Previous information suggesting the outcome: GenZ is lazy Outcome or current information: GenZ workers have more attrition rate (a biased person might say, that he/she had predicted this outcome because he considers them lazy)

Hindsight Bias is being overconfident about your predictions after the outcome. This can leadto poor decision making especially in investing, as investing is more about numbers, data and analysis than feelings. To overcome hindsight bias, investors must maintain a journal for decision-making and review it to improve the decision-making process.

Additional Read: What is Information Bias?