You’ve probably heard the expression “hindsight is 20/20.” That saying summarizes hindsight bias very well. With hindsight bias, people feel like an event was inevitable and predictable. Before the event happened, though, it wasn’t obvious that one outcome was obviously more likely than another.
Hindsight bias in investing often happens when a company’s share value increases or decreases sharply. Once the stock’s value moves, everyone seems to believe that the direction was inevitable. Oddly enough, there wasn’t a strong consensus before the value changed. That’s because the hindsight bias warps your perception to make you believe you could have predicted an event.
An Example of Hindsight Bias
You can spot hindsight bias in many parts of life. Think about watching a football game. At the beginning of the game, fans are thrilled as teams move up and down the field. You might want a specific team to win, but you enjoy watching the game because you never know what will happen. Each play creates an opportunity for the score to swing.
When the game ends, though, you will hear people say things like, “Well, obviously Team A was going to win because they have a better quarterback and they spend a lot of time practicing in the rain!”
In hindsight, it might seem impossible that the other team could have won. From within the hindsight bias, only the winner could have succeeded. The loser never had a chance.
How Hindsight Bias Can Affect Your Investing
Hindsight bias might sound benign since it changes your perspective after an event has happened. You might not worry about the effects of hindsight bias on investing because it doesn’t matter how your opinion changes after a stock goes up or down.
In reality, hindsight bias might influence your future investing decisions.
You Become Overly Confident
Hindsight bias can create the impression that you know more than you actually do. It’s important to remember that you didn’t truly predict an outcome. The outcome just seems obvious after it has happened.
Let’s say you read several opinions that Company X’s stock price will skyrocket within a few days. You believe these opinions, so you spend $5,000 buying shares. You know there’s some risk involved, but you’re willing to accept that risk to earn a strong return.
A month later, the company falls short of its projection and the stock price falls by 50%. You just lost half of your investment’s value!
At this point, hindsight bias creeps into your thinking. You shake your head and think, “I knew that company wouldn’t meet its goals. I should have listened to my gut instead of believing those analysts!”
Of course, you didn’t know that the company would miss its projected earnings. You agreed with the analysts when you read their opinions. After the fact, though, hindsight bias revises your memories to make you think you know better all along.
Over time, these events can make you overly confident in your opinions. From your perspective, you always know how the market will evolve. Really, you were only correct after you saw the market change. You think you have a lot of evidence that shows you’re an infallible investor, but the evidence is false. Now, you feel overconfident even though you make the same mistakes as other investors.
You Learn the Wrong Lessons
Hindsight bias can skew your interpretation of why successes and failures happen. As a result, you can learn the wrong lessons.
In the winter of 2024, you might have purchased Ulta Beauty shares because you saw the company’s stock price going up. You didn’t want to miss out on the opportunity, so you spent about $1,600 acquiring three shares. In March, Ulta Beauty’s share price falls from about $530 to $440. It happens so fast that you don’t have time to pull your investment.
How do you respond?
Hindsight bias will encourage you to believe that the stock price was always going to slip. You never should have believed the price could continue moving up. You decide that you’ll never purchase an on-the-rise stock again.
Is that really the lesson you should learn? Plenty of companies are worth investing in even while their share prices grow. Avoiding all high-growth stocks in the future sounds like a mistake.
Instead, maybe you should have learned to do more research before buying shares. Or maybe you should’ve learned that you don’t have enough capital to risk money on shares that cost more than $500 each.
How Do You Sidestep Hindsight Bias When You Invest
Hindsight bias is a normal cognitive error that everyone experiences. So, how do you minimize its negative influence on your investing?
Follow a Solid Investment Strategy
It’s important to have an investment strategy that guides your decisions. There are lots of investment strategies to consider, including growth investing, value investing, and passive index investing. Regardless of the approach you choose, you need to make it the driving force behind all of your decisions.
By establishing and following an investment strategy, you make it less likely that hindsight bias will interfere with your future trading decisions. Instead of letting the bias influence your choice, you can follow a process that helps you move closer to your financial goals.
Track Your Decisions and Rationales
Hindsight bias has the power to change your memories. When you miss out on an opportunity that triples someone else’s investment, you might think, “I knew it all along. Why didn’t I invest?”
The truth is that you didn’t choose the investment because it didn’t match your strategy. In hindsight, though, it’s hard to remember the facts.
If you want a good tip on sidestepping the bias, jot down in a notebook the trades you made and why you made them. That way when you look back in a few months and scrutinize your trades to see why they did well, or not, you can scroll through a journal of logic and quickly hone in on why things didn’t work out.
Get Information From Diverse Sources
A big lesson also is to infuse your decision-making from a wide variety of sources versus being wholly reliant on a single one. One of the greatest traits of the likes of a Stan Druckenmiller is pivoting on a dime, and re-assessing the logic behind a trade frequently.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.
