How Hindsight Bias affects Investing decision?

Som Thapa/Investopaper

Introduction

Nepal Stock Market in on a bearish trend since its peak of 1881 in 2016. The stock market currently stands at 1130 level, a fall of around 40 percent from the peak. This severe market crash resulted in the huge loss of wealth of many investors.

At current, if we ask the investors whether they knew the market was going to bust after 2016, then many would reply that they knew all along that the market would crash. However, at the peak level, investors were more optimistic about the market. This can be seen by the huge amount of daily turnover. The daily transaction amount stood at around 1.5 to 2 billion rupees.

So, how does the perception of investors change for the same event? This is a psychological phenomenon known as ‘Hindsight bias.’

Hindsight bias refers to the tendency of people to view events as more predictable than they actually are. In other words, it makes the past seem more predictable than it actually was. Things always seem more obvious after they have already happened.

Before the event, due to the lack of information and foresight, decision making is relatively hard. However, after the event, looking at the result available, the outcome seems more predictable.

In the case of our market, during the bullish period, investors were unaware of the impending market crash. So, many were heavily invested in shares. There were some who had a guess that the market might collapse. However, no one was completely sure at that time.

After the market collapse, however, the investors feel that they knew that the market would crash. With the increase in information available about the market crash, investors seem more confident about the predictability of the event.

As the wise men say ‘Focus on the process, not on the results’.

Why Hindsight bias can be dangerous in investing?

Let’s look into the scenario: You think of buying a stock named ABC. However, for some reason, you don’t buy it. Then the price of stock ABC skyrockets. How do you feel?

The answer is you feel stupid. You kick yourself for the missed opportunity. You remorse over not buying the stock since you knew that the stock was a winner. ‘I knew it for sure that the stock would rise’ is the statement you repeat to yourself. This is the hindsight bias we are talking about.

Why is it dangerous then? This is because you vow to yourself that you will not repeat the same mistake again. You feel more confident in your decision making and you promise to grab the next opportunity. Herein lies the danger that hindsight bias can lead to. Next time may not be the same as the last time.

Again let’s look into a different scenario: You think of buying a stock named ABC. However, for some reason, you don’t buy it. Then the price of stock ABC crashes. Now ask yourself, Would you feel the same as in the first case?

The answer is No. You congratulate yourself for making a sound decision of not purchasing the stock ABC. You knew that the stock would fall which is why you didn’t purchase the stock in the first place.

Why does the answer differ in these two scenarios? Ideally, the answer in the two scenarios should be the same. Before the rise or fall in the price of stock ABC, you made the same decision of not buying it in both cases. However, after the happening of the event i.e. rise/fall in price, you adjust your reaction according to the nature of the event.

This is dangerous because it gives you ‘I knew it all along’ vibe, a false sense of security in your judgment. This can make you overconfident in your skills in investing and can lead to rash decision making.

How to avoid the Hindsight bias trap?

Several behavioral experts have suggested making note of all the things that were considered while making the decision. This might be a good idea. If we keep the note of the reasoning behind our decisions, we will know what was our thought process at the time of decision making. We cannot manipulate our statements after the occurrence of the event. This will help us in the fair evaluation of our ability.

Hindsight bias may not seem threatening to the investors. But, it can elude you into making decisions based on your perception rather than facts.

Conclusion

Hindsight bias is happening in our everyday life. Whether it be investing or games or examination or others, we feel much surer in our ability after the result. If Real Madrid won the game against Sevilla, we tell ourselves and others that we knew that Madrid would win surely. Similarly, if the price of the stock/real estate is on the rise, ‘I knew it’ comes into play.

Even if it may not have caused any damage now, it can make you overconfident and your next bet may be more irrational. Real Madrid won but the result can be different next time. Past events cannot be fully used to forecast the future. With changing times, information and strategies change.

Hence, it is better to take every opportunity as new and make your decision based on the facts. The past always seems easier to predict but it ain’t so. It is a delusion created after the occurrence of the result. So, it is better to stick to your investing philosophies and strategies.

As the wise men say ‘Focus on the process, not on the results’.

 

 

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