Hindsight is 20/20. Haven’t we all heard that before? From sports to legal trials and political elections, many of us have felt that we expected the outcome all along—even if we really didn’t.
Are we being dishonest with ourselves and others when we say this? No. According to psychologists, it’s a common phenomenon called hindsight bias.
This inflated sense of foresight that develops in the aftermath of an event also happens among investors when they review their past investment decisions. An entire field called behavioral finance, which combines cognitive psychological theory with conventional economics and finance, has been developed to try to explain why people make illogical or irrational investment decisions.
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Behavioral Finance and Hindsight Bias
The financial markets can be chaotic. Hindsight bias is our response to this chaos. Our brains combine distorted memories with our beliefs about the objective likelihood of an event. Add in some confidence in our personal ability to predict a given outcome, and the result is hindsight bias.
Hindsight bias acts as a filter that allows our brains to process the unfolding of events in a way that makes sense to us. It leads us to believe that the results were predictable, logical or even obvious—and conveniently gives us a built-in excuse if and when our predictions turn out to be wrong.
In the book Thinking, Fast and Slow, behavioral finance psychologist Daniel Kahneman says that “a general limitation of the human mind is its imperfect ability to reconstruct past states of knowledge, or beliefs that have changed. Once you adopt a new view of the world…you immediately lose much of your ability to recall what you used to believe before your mind changed.”
One example of hindsight bias is the bursting of the U.S. housing bubble in 2007. Leading up to it, homebuyers with less-than-desirable credit had committed to mortgages far beyond their means thanks to easy money in the form of subprime loans. These folks believed that real-estate prices would continue to rise, but instead, they came crashing down. Looking back, it’s all too easy to see the glaring red flags of the impending collapse. But, at the time, it was very hard for most people to predict.
Hindsight bias can lead to overconfidence in our decision-making abilities. It can convince us that we can predict the future based on events that happened in the recent past. It can also keep us from learning from our experiences, and from evaluating the reasons that something happened.
How to Avoid Hindsight Bias
Financially speaking, hindsight bias can tempt us to assume more risk than we can truly handle. One way to avoid falling prey to hindsight bias is by carefully analyzing your investment decisions prior to taking action, including identifying all potential outcomes.
Another way to avoid hindsight bias is to keep notes about your investment decisions as you make them, and review them as soon as you know what the outcome is. This may help you avoid future confusion that can stem from relying solely on your memory. It also can help you to evaluate what works about how you make decisions–and what doesn’t work.
Perhaps the best way to avoid hindsight bias is to work with an impartial third-party expert, like a financial advisor, who can’t be distracted by emotions or ego. An advisor can help steer you away from making poor decisions, and point you in a better direction.
If you’re ready to talk to an expert about how to make better investment decisions, click here to schedule a free, no-obligation appointment.