The Hindsight Trap: How to Avoid the Pitfalls of Overconfidence in Investing

Everyone in finance is Nostradamus. The uptick in inflation was obvious. The bear market was so predictable. It was clear that ABC Co. stock was going higher.

There’s only one problem with those three statements —  they aren’t true. Yet, when market pundits discuss past events, they describe them as inevitable. That’s why hindsight bias is also called the “knew-it-all-along” effect. We revise the past, which leads us to overestimate our ability to foresee the future.

Annie Duke began her book, Thinking in Bets, by tackling Hindsight Bias, attributing it to an “overly tight connection between outcomes and decisions” and explaining that “we link results with decisions even though it is easy to point out indisputable examples where the relationship isn’t so perfectly correlated.”

Let’s say you buy a stock. Within a few days, it’s almost equally likely that the stock will have gone down as up. If the price rises and you turn a quick profit, you’re likely to say, “I knew that would happen; I’m great at picking stocks.” In reality, the price could’ve just as easily fallen. 

Hindsight bias isn’t just bad because it misattributes the cause and effect of various events; it’s dangerous because it leads to behaviors that have negative and sometimes long-lasting consequences.

Overconfidence

After convincing yourself that you’ve accurately predicted a past event (whether you did or not), believing you can predict future events is more conceivable. An overconfident investor is a dangerous investor. The financial markets are humbling, especially when overconfidence leads to ultra-risky investment decisions based on a faulty memory of the past.

Being Unprepared

The world is full of surprises, but hindsight bias convinces us to let our guard down, like a boxer being lulled to sleep by his opponent. After a period of inactivity in a fight, a rival might suddenly unleash a flurry of punches, catching his complacent opponent off guard.

Admitting that we don’t know what’s coming is essential in mentally preparing for an unpredictable future.

Prevents Learning

Some investors make the same mistakes repeatedly. They aren’t (always) stupid; they’re biased. If you continuously re-write history, you can’t learn from past mistakes and are likely to make them again. 

Psychological scientists Neal Roese and Kathleen Vohs identified three levels of hindsight bias:

Cognitive

My wife occasionally accuses me of selective hearing. I deny having this ailment, but we’re all guilty of selectively remembering information that confirms what we already know (an internal version of confirmation bias). By curating our memory, we can create a narrative that aligns with our view of the world — known as “sensemaking.”

Metacognitive

When you catch yourself thinking about thinking, that’s metacognition. It’s how we access our understanding and performance. We’re prone to confuse the ease of recalling a previous thought with certainty.

Motivational

As cravers of order, we’re motivated to convince ourselves that unpredictable events are predictable. We also like the positive reinforcement of feeling “right,” so we’re motivated to alter the past to enhance our self-image.

Ultimately, we control our beliefs, values, and actions — nothing else. Admitting this is challenging but powerful. It allows us to direct our attention to areas we can influence and stop wasting time and energy on those that are out of our control. Similarly, we don’t know what the future holds. We like to make predictions, and we enjoy hearing others make predictions (especially bold ones), but, much to our dismay, we’re all pretty bad at predicting the future. 

By recognizing our cognitive limitations, like hindsight bias, we can make better decisions rooted in the reality of our constraints. When it comes to investing, an awareness of our susceptibility to the “knew-it-all-along” effect can help us stay humble, avoid overconfidence, and learn from our mistakes (instead of ignoring them). 

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from James Vermillion, and all rights are reserved.