How hindsight bias shapes investment decision making

DN89...Jybs

7 Apr 2024

Hindsight Bias

Bitcoin has been on a bullish trend since 2023. Investors are overjoyed by the huge return offered by the crypto market in a short period. At present, if we survey investors asking whether they knew the market was going to go up in 2023, many would confirm that they knew all along that the market would rise.

However, before the bull run, the market was in severe correction and fell to as low as $15,000. During this low point, investors were highly pessimistic about the market. Instead of increasing investment, many investors sold their Crypto at low prices and got out of the market. If we had then surveyed investors asking whether they knew the market was going to go up in 2023, most would probably say no while many would feel unsure.

But at present after the sudden rise in the prices, many investors are sure that they knew the market would rise. 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 are. In other words, it makes the past seem more predictable than it 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 results available, the outcome seems more predictable.

In the case of Bitcoin, during the bullish period, investors were unaware of the impending market crash. So, many were heavily invested in Crypto. Some guessed that the market might collapse. However, no one was completely sure at that time.

After the market collapse, however, the investors felt 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.

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 have 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. 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. The 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 an ‘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 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 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 crypto/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.