Hindsight bias
Behavioral New World
Hindsight Bias
March 1, 2021
“Don't look back. Something might be gaining on you.” —Satchel Paige
Far be it from me to second guess such good advice. Staying focused on your goals, not letting distractions interfere, not worrying about that which you cannot control—all that certainly makes sense.
But what might you do when you get to the goal? Or even just a milestone on the way to the goal? Doesn’t it make sense to look back, to see what has gone right and what has gone wrong? There’s an obvious opportunity for learning from both.
Let’s imagine an investment. And for the sake of my narrative today, let’s say it is you – a retail investor – who has decided to purchase a stock. (Not that I’m an advocate for retail investors buying individual stocks, but that’s for another time.)
Investopedia defines hindsight bias as “…a psychological phenomenon that allows people to convince themselves after an event that they had accurately predicted it before it happened….it is a common failing of individual investors” (and, I would add, almost all financial decision makers).
How does this apply to our investment scenario? Let’s first consider that your investment has been successful. Obviously, you feel good about it. But hindsight bias says that you think of the successful outcome as having been almost destined, a near sure thing, that you knew at the time that it would be successful. But objectively speaking, that notion cannot be accurate—there are no guaranteed investments. Put differently, after the fact, you interpret the outcome as having been much more probable than it actually was before the fact.
The danger here: This experience can lead you to believe than you can presciently predict other events. You may become overconfident (overconfidence was the subject of my September 1, 2020 newsletter under the heading, “Hubris”). In turn, your overconfidence can lead to bad decisions, especially the possibility of taking too much risk.
Now let’s consider the scenario in which the investment is a flop—the stock goes down 50%. Here, there is an all-too-human tendency to say, “Well, I had a feeling it wouldn’t work out.” Problem: Re-writing history in this way makes it difficult to take a hard look at what went wrong. But the looking back is critical to making better decisions in the future. For example, was it something that was out of your control (e.g., a pandemic) or was some shortcoming of your analysis? There’s a big difference between the two.
What can we do about hindsight bias? Richard Thaler, behavioral economist and Nobel Prize winner, has a simple solution: Write everything down as you are making the decision.[1] This simple act records your thinking at the time. By doing so, it offsets our natural hindsight bias. We can review what we were thinking rather than relying on our biased memory.
For example, a stock comes to your attention. Assuming it has some appeal, reach immediately for your investment diary. Record how it came to your attention and what you initially find attractive about it. Then, presumably, you do some research into the company. Briefly summarize what you find (for example, its sales have been growing rapidly) and your reasoning about whether or not to purchase the stock (for example, you think the sales will keep growing).
Then months or years later, once the investment has either failed or succeeded, take a look in your diary at what you were thinking at the time you decided to get in. I think you will be surprised. Did sales fall short because Amazon decided to carry a similar product? Did the company’s supply chain get disrupted? You might not have thought of either of these somewhat predictable events. This process, unfamiliar and perhaps disagreeable as it might be, allows us to become better decision makers.
Satchel Paige was correct. He wasn’t a baseball legend for nothing. However, there is value in looking back, not to see what’s gaining on you, but to evaluate your decisions to become better at them. But that process won’t yield the highest possible benefit if you don’t work conscientiously to understand and offset hindsight bias. If you do, you might just notch up more four-baggers than you ever thought you could.
(I knew that this newsletter would turn out to be just the right length.)
[1] “Debiasing the Corporation: An Interview with Nobel laureate Richard Thaler,” McKinsey Quarterly, May 9, 2018.