By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: November 21, 2011
An understanding of hindsight bias and other aspects of behavioral finance can make you a better investor by increasing awareness of the irrational forces that can drive investment decisions. While traditional economics assumes that investors act rationally, behavioral economics combines the study of psychology and economics to explain some of the irrational biases that affect investment decisions. One of these is hindsight bias.
Hindsight bias is your sense that, after something happens, you somehow “knew it all along.” This occurs because actual outcomes are more easily comprehended and remembered than the many possibilities that did not materialize. It is this tendency that causes people to overestimate the accuracy of their predictions. In turn, this overestimation of predictive accuracy is very dangerous because it leads to overconfidence and an underestimation of uncertainty.
Did You Really See That Bubble?
The perceived ability to spot a bubble after the fact is a great example of hindsight bias in action. Very few people in 1999 or 2008 were forecasting that the bubble in financial markets would burst. Yet, looking back on the two bubbles, many people feel that, at the time, they actually “saw all of the signs” that the bubbles would burst. The human mind has a tendency to forget the many reasons why this did not seem so obvious at the time.
An experiment conducted by Baruch Fischoff provides valuable insight into the mind’s tendency to overestimate our own abilities. Fischoff had subjects answer questions from almanacs and encyclopedias for a “general knowledge” test. He then conducted a “memory test” on the same subjects by revealing the correct answers and asking his subjects to try to remember their original answers. Although they tried hard to do well on this “memory test,” the subjects incorrectly “remembered” a disproportionately high number of correct answers. The results indicate that memory of the past is clouded by the tendency to overestimate the accuracy of past decisions.
A False Sense of Security
One of the most important implications of hindsight bias is that it gives investors a false sense of security when making investment decisions. Overestimating the accuracy of past forecasts can lead to excessive risk taking and can lead investors to plan for outcomes that may seem obvious, but actually involve much more uncertainty than they perceive.
Hindsight bias manifests itself in comments like, “This new IPO is the next Google. I knew Google was going to do well, but didn’t buy the IPO. I’m not going to make the same mistake again.” The reality is that, at the time of its IPO, Google’s success was a lot less certain than it now seems. Investors seeking to replicate the success of Google with another stock may be setting themselves up for disappointment by not adequately accounting for the likelihood of less favorable outcomes.
Taking the Good with the Bad
In order to understand hindsight bias, you need to admit your susceptibility. Many people subconsciously block memories of poor investment decisions and recall successful decisions at a rate that far exceeds their actual results. In order to become a better investor, you should focus on objectively evaluating all of your investment decisions, both good and bad. Only by assessing your weaknesses along with your strengths can you avoid repeating past mistakes.1
1 Michael Pompian, Behavioral Finance And Wealth Management (John Wiley & Sons, Inc., 2006), 199-207
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.