Hindsight bias is a phenomenon in which people overestimate their capacity to predict an event when it is not possible to do so before its occurrence. Hindsight bias is a part of behavioural economics and generally takes place in the investment field. For example, traders tend to get the hindsight bias when three is a buying pressure and investors overlook the past trend. As a result, the investor might face losses.
The hindsight bias is also known as the knew-it-all-along phenomenon and creeping determinism. For example, a person places a bet on a team winning a cricket match, and the odds of that team winning are very low. In case the cricket team wins, then the person claims that he/ she had a feeling that the team will win.
The hindsight bias creates confidence in the person that they have the capability to foresee future outcomes or events, if the person is able to make any correct prediction.
The hindsight bias can occur while making a big decision or a very small decision. For example, an investor feels pressure while taking a long position in the market with the aim of maximization the return. In case the investor loses his money, then the investor will indicate he/she knew beforehand that they will face a loss and this feeling comes after the regret. It is possible that the investor might have predicted the loss, but in both cases, the investor is convinced that they know it would happen.
From the long term perspective, hindsight bias can have a negative impact on the decision making capability of an individual. Good decision making involves assessing the consequences. With hindsight bias, the individual might gain overconfidence in their personal capability to predict the future. If a person has a strong belief that they can see the future as they were earlier able to do so, it can lead to taking unnecessary risks.
To illustrate, a gambler thinks that he/she can predict the future as he/she was able to predict the outcome during his/her visit to the casino. During his/her next journey to the casino, he/she will be confident to make a profit with the ability to predict the outcome.
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The hindsight bias can have a significant impact on the professional and academic areas. The predictions in the field of the law, academics or politics can be affected significantly. The researcher can overlook or taint the historical facts, or the trends or the political events while making a decision as they are unable to look at the perspective of the past decision makers. Industries like insurance, finance and law rely on risk assessment by analyzing historic events. The presence of hindsight bias can impact the accuracy of the predictions.
In finance, it is generally recommended to keep a record of the investment decisions and assess them to know the reason behind the success or failure. By mapping past decisions, it becomes easy to make decisions in the future. A record also allows mitigating the risks associated with the hindsight bias.
Hindsight bias does not allow the investor to learn from the mistake or recognize the event that led to the loss. The bias limits the capability of a human to learn as the person starts to believe they already knew that the event would occur along with an increase in the confidence to commit the same mistake again.
Therefore, it is recommended that, in the field of investment, a diary should be maintained in which the investor records all the decisions which state the reasons for taking a particular investment decision. This keeps a check on the hindsight bias.
After financial bubbles burst, they are subject to hindsight bias. During the great recession of 2008 and the dot-com bubble, many analysts demonstrated that they have an idea about the occurrence of these events. In case, the analysts have predicted the occurrence of events, then the events might be protected altogether and protecting large masses from large losses.
Many people regret the thought of not buying the apple or Microsoft stocks in the 1980s and these investors claim that they know that the companies will boom in the future. These investors are affected by hindsight bias. It is recommended that an investor should carefully evaluate their ability to predict the future outcomes on the basis of the current events. In few cases, the current events have no impact on the future, still, people believe that they know the future. The overconfidence regarding one’s capability to predict the future can result in taking a position in the stocks based on intuition rather than thorough analysis.
Intrinsic valuation and hindsight bias - Hindsight bias can result in taking investment decisions without considering the analysis of the company in an objective manner. By utilizing the intrinsic valuation method, the investor will be able to make investment decisions on the basis of the data rather than the personal intuitions. Intrinsic valuation stands for arriving at the true value of a stock by analyzing all the business aspects along with the situation of the current market.