IMPORTANT INFORMATION TO ADVISERS
This material must be modified to satisfy your own advisory obligations.
DISCLAIMERS
You may choose to cut and paste all or part of this publication into your own business
branded template.
This document has been prepared by Colonial First State Investments Limited ABN 98
002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of
current regulatory requirements and laws as at 10 March 2014. While all care has been
taken in the preparation of this document (using sources believed to be reliable and
accurate), to the maximum extent permitted by law, no person including Colonial First
State or any member of the Commonwealth Bank group of companies, accepts
responsibility for any loss suffered by any person arising from reliance on this
information.
Hindsight bias
Behavioural investing series #2
Introduction
After an event has occurred, people often look back and convince themselves that
the outcome was obvious and likely, and that they could have predicted it. This is
known as ‘hindsight bias’, or the ‘knew-it-all-along’ effect. In actual fact –
particularly in the investment world – outcomes can rarely be reasonably predicted
ahead of time.
Hindsight bias is common and can be attributed to our natural need to find order in
the world. We create explanations that allow us to make sense of our surroundings,
and that help us to believe that events are predictable.
The human ability to find patterns and to link cause and effect can be useful - for
example, to a scientist carrying out experiments. However, finding false links
between an event and its outcome can sometimes result in unreliable oversimplification.
Studies1 have also shown that hindsight bias occurs because it’s easier for people to
understand and remember the actual outcome than it is to consider the many other
possible outcomes that, in the end, didn’t come to pass.
Jacoby, L. L. (1978). On interpreting the effects of repetition: Solving a problem versus
remembering a solution. Journal of Verbal Learning and Verbal Behavior,17, 649 – 667
1
Given how important investment decisions are in our everyday lives, hindsight bias is
frequently observed among investors.
Impact on investment decisions
One of the most significant effects of hindsight bias is the way in which it can
influence investment decisions.
It does this by encouraging investors to over-estimate the accuracy of their past
forecasts. This leads to a false sense of security, causing investors to assume that
their future forecasts and decisions will be equally accurate.
As a result, investors often make decisions based on future investment outcomes
which may seem obvious and highly likely to them, but actually involve much more
uncertainty and risk than they realise.
Philip E. Tetlock, a professor of management at the Wharton School of the University
of Pennsylvania, has studied people’s tendency to exhibit hindsight bias. “Even after
it has been explained to you 100 times, you can still fall prey to the bias” he has
said. “Indeed, even after you’ve written about it 100 times.”
The ability of investors to identify a bubble after it has burst is a classic case of
hindsight bias. In both 1999 and 2007, for example, very few investors correctly
forecasted that stock markets were about to fall. However, when we now look back
at those times, it’s often felt that the signs of what would happen next were clear
and there for all to see.
Case study
Hindsight bias can be illustrated by the following case study and chart. In this
example, our investor William invests in two stocks during 2013.
In January, after much research, William decides to invest in Company A. The share
price soon increases substantially in value. William is delighted – his research has
paid off! He congratulates himself on his perception and investment insight.
In December, William decides to invest again. His success with Company A gives him
confidence that he will be able to pick another winning stock. This time, William
invests in Company B.
Of course nobody can be certain how Company B’s shares will perform, including
William. But he is more confident in his expected (positive) outcome for Company B
– and less focused on the wide range of other possible investment outcomes for its
share price – than he might have been before his success with Company A.
In short, hindsight bias has led William to become over-confident in his stock-picking
skills.
Illustrative purposes only.
Eliminating hindsight bias
The first rule of avoiding the common investment pitfalls associated with hindsight
bias is to be aware that it exists.
Even experienced investors can never be certain how particular investments will
perform in the future. Investors must always balance risk and return, placing equal
emphasis on all factors that have impacted previous investment decisions, both
successful and unsuccessful.
Doing so will provide investors with a clearer and more balanced perspective to their
decision-making process. Maintaining this focus can enable investors to avoid the
unfounded over-confidence in their predictive abilities that hindsight bias can trigger.
An alternative approach would be to invest in a managed fund, run by a professional
investment manager. Investment managers tend to follow consistent, repeatable
investment processes which can help eliminate hindsight bias from investment
decisions.
Speak to your financial adviser if you have any questions about hindsight bias.