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“I knew it all along” – Avoiding the Hindsight Bias Trap

“I knew it all along” – Avoiding the Hindsight Bias Trap

How many times have you looked back at some event that, at the time, was a surprise but with the benefit of hindsight seemed so obvious? It happens frequently, and the common adage of “hindsight is 20/20” gets repeated all the time. It’s the tendency for people to look back on an event and say “I knew it all along!” In reality it would have been impossible to “know” for sure the outcome until after it occurred.
In investing this also occurs on a regular basis and is known as “hindsight bias.” This bias helps people save face after a bad decision (I knew that was going to happen), and possibly the most dangerous effect in investing is creating over confidence after a series of good decisions, which then leads to excessive risk taking.

For example, over the last 18 months many health care and biotech stocks have been soaring. Fifty, seventy-five and even one hundred percent gains in a short period of time have been common. With hindsight bias at work, investors can fall into the trap of thinking the reason this sector has done so well is obvious, and have a false impression that this is what will happen going forward. A large portion of their portfolio gets allocated to one sector because they believe their predictive skills are finely tuned. Too much confidence in one’s predictive ability can be harmful to one’s wealth.

Another great example is when market “bubbles” burst. Going back to the dot-com crash of the early 2000’s, or the financial melt-down of 2008 it’s very common to hear phrases like “everyone knew it was going to crash,” or “of course the bubble burst.” However, in the midst of those events it is never that clear.

One of the ways to become a better investor is to learn from past investment mistakes. Hindsight bias can get in the way of that. After the fact it’s very easy for people to attribute the wrong reasons why an investment didn’t go well and, conversely give the wrong reasons why a certain investment did very well.

A good way to overcome this bias is to keep notes at the moments you are making your investment decisions. Do your analysis, write down the reasons why something is being bought or sold and keep a journal of your decisions. This way you can look back and read your actual notes from months and years ago, and not be subject to hindsight bias’ revisionary history.

This also reinforces the idea that investing process trumps investment product. The focus should be on the process of how you make your investment decisions, and by fine-tuning, practicing, and continually improving the way you make your investment decisions your track record will improve and you will see a bright investment future.