Described in simple terms, hindsight bias is the impulse that insists: “I knew it all along!” Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable – even if it wasn’t. This behaviour is precipitated by the fact that actual outcomes are more readily grasped by people’s minds than the infinite array of outcomes that could have but didn’t materialize.
Therefore, people tend to overestimate the accuracy of their own predictions. This is not to say, obviously, that people cannot make accurate predictions, merely that people may believe that they made an accurate prediction in hindsight.
This affects future forecasting, because a person subject to hindsight bias assumes that the outcome he or she ultimately observes is, in fact, the only outcome that was ever possible. Thus, he or she underestimates the uncertainty preceding the event in question and underrates the outcomes that could have materialized but did not.
One detriment of hindsight bias is that it can prevent learning from mistakes. People with hindsight bias connected to another psychological bias, anchoring, find it difficult to reconstruct an unbiased state of mind, simply because it leads people to exaggerate the quality of their foresight.
When hindsight-biased traders have a winning trade, they tend to rewrite their own memories to portray the positive developments as if they were predictable. Over time, this rationale can inspire excessive risk-taking, because they believe they have superior predictive abilities.
Hindsight-biased traders also “rewrite history” when they fare poorly and block out recollections of prior, incorrect trades in order to alleviate embarrassment. This form of self-deception, in some ways similar to cognitive dissonance, prevents traders from learning from their mistakes.
What is the best solution for this?
In order to overcome hindsight bias, it is necessary, as with most biases, for the trader to understand and admit their susceptibility. One way to face the facts is to keep a trading journal, and use it to record your analysis and reasons for every trade, as well as the thought-process and emotional swings that went with the whole trade. This will be useful when you look back to the past after the event, and will prevent any disillusioned thinking.
“You didn’t know it all long; you just think you did.”
– James Montier