What is Hindsight Bias?

Hindsight bias refers to a psychological phenomenon in which people convince themselves that they correctly predicted an event before it occurred. People may think as a result of this that they can accurately foresee future events.

In Behavioural Economics, hindsight bias is examined since it is a widespread flaw among individual investors.

Briefly Understanding Hindsight Bias

When a person looks back on any event, they believe they could have foreseen the outcome. This is known as hindsight bias. It suggests that the majority of people believe their judgment is superior to what it is. The argument is that knowing the outcome makes it much easier to come up with a believable explanation. As a result, we become less critical of our decisions, which leads to poor future decision-making.

Investors are frequently under pressure to time their stock purchases and sales properly to maximize their profits. When they suffer a setback, they lament the fact that they did not act sooner. With remorse comes the realization that they should have seen it coming from the start.

It was, in reality, one of the numerous scenarios they may have foreseen. Regardless of which one succeeds, the investor is persuaded that they saw it coming. This permits investors to make poor selections in the future without even realizing it. To avoid hindsight bias, the investor must make forecasts ahead of time, such as by keeping a decision-making record that can be compared later.

What Causes Hindsight Bias?

When new information about a former experience becomes available, it causes hindsight bias, which alters how we remember that experience. Only the information that verifies what we already know or believe is true is remembered.

After the fact, hindsight bias entails adjusting the probability of a result. A person will overestimate the extent to which they predicted the outcome after they know it. These biases can be observed in almost any situation, including weather forecasting and election predictions.

Overconfidence and anchoring are at the Basis of hindsight bias. We use the outcome's knowledge as an anchor to tie our earlier judgments to the outcome once an event occurs. The problem may be partly scientific. Whereas hindsight bias may not be exclusively due to inefficient information processing, but is founded in adaptive learning and has evolved. The brain can assist in preventing memory overload by updating previously held facts.

People and society are prone to hindsight bias because it is reassuring to believe that the world is predictable and orderly. As a result, we try to make unpredictably unexpected events predictable. We use sensemaking to develop a story or narrative that indicates we were aware of the outcome to have a favourable picture of ourselves.

Avoiding Hindsight Bias

When assessing their abilities to foresee how current events will affect the future performance of securities, investors should exercise caution. Believing in one's ability to anticipate future outcomes can lead to overconfidence, leading to picking stocks or investments based on a hunch rather than on Financial Performance.

Keeping a notebook or diary is one of the most straightforward strategies to avoid hindsight bias. This will provide a record of your decision-making process, allowing you to go back and review why you reached the conclusions you did. A paper like this will primarily assure that you can appropriately reflect on a circumstance. These decision notebooks can help you keep track of when and how you made decisions.

This gives you a better understanding of what you expected to happen when you made your decision. It's also necessary to weigh all information, including providing valuable information more weight.

A decision journal can assist you in making better decisions in the future and reduce second-guessing. Understanding what went wrong might be aided by adequately assessing the results (or right).

Intrinsic Valuation

Investors can be distracted from an objective view of a firm by hindsight bias. Sticking to intrinsic valuation approaches allows them to make data-driven decisions rather than emotional ones. Intrinsic Value refers to the stock's intrinsic value's perception based on all business characteristics and may or may not be the same as the present Market value.

An excellent mathematical model is most successful at avoiding hindsight basis. This eliminates the guesswork and bias that comes with analyzing a business—using quantitative criteria, such as financial statements and ratios, in particular. Intrinsic worth, however, has its limitations.

Notably, there is no standard method for calculating intrinsic value. There are numerous models or valuation techniques to choose from. Some assumptions must be plugged into any model, and these assumptions can lead to bias.

Quantitative and Qualitative Analysis

A qualitative component such as a company's business model, corporate governance, and target market would usually be included in an intrinsic valuation. Quantitative factors like financial statement studies can reveal if the current market price is accurate or whether the company is overvalued or undervalued.

Analysts commonly use the Discounted cash flow model (DCF) to calculate a company's intrinsic value. The DCF considers a company's free cash flow and its Weighted Average Cost of Capital (WACC).