Hindsight bias. Was the market correction of 2022 a negative surprise for your asset allocation strategy, or did you ‘know it all along’?

Hindsight bias is a cognitive bias whereby people believe they could have predicted an outcome after it occurs. It can lead to excessive risk-taking and hinder learning from past mistakes. Discover whether you are prone to a hindsight bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural science. What is hindsight bias?

“I knew it all along!” This is a behavioural pattern whereby a person tends to view the actual outcome of an event as entirely predictable and to overestimate his ability to foresee the outcome after it has occurred. The belief is held despite the result not being predictable and where many outcomes were possible. For example, many investors today say that the only possible consequence of quantitative easing was a rising stock market and that the US housing bubble was obvious to predict before 2007-08. Worse, a person’s confidence in ‘correctly’ predicting the future can grow over time, inspired primarily by hindsight bias and not by superior forecasting ability. Persons with strongly pronounced hindsight bias tend to remember only correct investment decisions, forget their past mistakes, and believe strongly in their perfect foresight. This way, they deprive themselves of learning from the past, which is critical in asset allocation strategies.

Hindsight bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education. 

What are the consequences and portfolio risks?

Such investors tend to fall into excessive risk-taking over time. The same is true for asset managers: hindsight bias leads them to falsely believe in their forecasting abilities and to take extreme risks on behalf of their clients. Similarly, hindsight bias also drives discontent with good asset managers: their mistakes may seem obvious after the effects of the error become clear. However, these mistakes could have been difficult or impossible to predict. Many cases prove that excessive risk appetite results in mistakes and poor investment results.
 

What can I do to make my portfolio optimal? 

First, admit that your behaviour might sometimes exhibit patterns of hindsight bias. It is not easy to recall all your good and bad investments, but the habit of reviewing the reasons and assumptions for the investment before and after would help a lot. Many prominent successful risk-aware investors write down their thoughts before making any investment and, regardless of profitability, scrutinise these assumptions later. By doing this, they have plenty of information to learn from and have documented grounds to remember past decisions correctly without hindsight bias.