It is a documented psychological phenomenon in which people exaggerate the predictability of an event after it has already happened. Some psychologists refer to hindsight bias as the “I knew that was going to happen” effect or “I-knew-it effect. You can probably find a few examples of hindsight bias in a pub after a major sports event, with people claiming that the outcome was obvious and predictable. The hindsight bias is one of many such biases, and according to a study performed by the American Psychological Association in 2000, the hindsight bias actually helps people think more clearly sometimes, by helping the brain to retain correct and relevant information rather than incorrect information.
You can probably think of a few examples of I-knew-it-effect or hindsight bias in your life, especially if phrases like “hindsight is also 20/20” and “I told you so!” sound familiar to you. Hindsight bias works in a number of ways, and it is especially important to take hindsight bias into account in criminal cases, because a witness may not be strictly accurate, since he or she may be influenced by hindsight bias, along with a number of other biases which can influence the way someone's brain restores and recalls information.
A classic example of a hindsight bias occurs when someone claims that his or her prediction about an event was more significant that it really was. For example, someone might generally observe that “it looks like rain in the future,” given his or her general knowledge of local weather patterns. If it rains shortly after this statement is made, the person might feel that the prediction was stronger than it really was. Incorrect or inaccurate predictions tend not to be remembered as well as vaguely correct predictions, reinforcing the idea in someone's mind that his or her predictive skills are better than they really are.
In a specific phenomenon called vaticinium ex eventu, someone makes an extremely vague statement about an event which might occur, and then turns that statement into a solid prediction after the event has occurred. This is sometimes scathingly called “postdiction.” Many examples of vague predictions which were later thought to be more important than they actually were can be found in Greek mythology, where the cryptic oracles make blanket statements which could easily be said to be predictive of a great number of events.
Along with several other biases documented in psychology, the hindsight bias is caused by something known as an availability heuristic. Essentially, people make assessments about things on the basis of information which they can bring readily to mind, although this may not be the most scientific way to base such an assessment. For example, someone might visit a particular franchise in a fast food chain and note that all of the patrons there are overweight. He or she might then say that all patrons of that chain are overweight, on the basis of this single example. In the case of hindsight bias, people turn a few vague statements into solid predictions, and assume that an event like the outcome of a Presidential election is predictable on the basis of their experiences.
"I should have caught the move"
"I knew that was going to happen"
"If only I had followed my signal"
When markets become unusually volatile, they make unusually large moves. To the short-term trader or the active portfolio manager, such moves look like phenomenal opportunity. This creates a kind of dissonance when their results do not reflect such opportunity. This dissonance is often expressed as regret: the word "should" becomes a prominent part of traders' thinking.
Underneath this regret is what behavioural finance researchers call "hindsight bias": the exaggerated sense of predictability in retrospect. Very often, traders will have reasons in mind why the market might rise and they can identify reasons why it might fall. The evidence from research, charts, fundamentals, and indicators often paints a mixed picture. In retrospect, however, traders will look back on market outcomes and selectively pick out the evidence that would have predicted the market's movements. They minimize the ambiguity that occurred at the time and convince themselves that they knew all along what the market was going to do.
It's easy to see how hindsight bias and regret go hand in hand. If you convince yourself that you saw the market move in advance and you see that you didn't participate in the move, the dissonance between what your profitability should be and what it is leaves plenty of room for self-recrimination. Out of this regret, traders often feel pressure to make up for the "missed opportunity", leading to overtrading.
A psychodynamic psychologist would view hindsight bias as a kind of defence: it protects traders from the anxieties of ambiguity and unpredictability and reinforces an illusion of control. A number of behavioural finance investigations have shown traders charts composed of random price movements; invariably traders find meaningful patterns in the randomness. For them, the anxiety may not be the market going up or down; the anxiety is not knowing what the market will do.
It takes a strong psychological constitution to tolerate such ambiguity and uncertainty. And yet, it is precisely the embrace of the market's uncertainties that allows us to be alert to risk and implement proper risk management. Hindsight bias appears to be a natural response to an updating of information regarding events; it's part of how we make sense of our world. As Richard Peterson notes in his book "Inside the Investor's Brain", research from Paul Slovic finds that the best antidote to hindsight bias is a hard, purposeful look at "counterfactuals". Once a market event occurs, considering the array of alternative outcomes and their implications helps moderate hindsight bias and associated regret.
Given the limits of what we know and what is ultimately unknowable, not all movement is opportunity. The key to trading success is finding the patience to capitalize on those things you do know and the wisdom to accept what is uncertain.
If we are not willing to be wrong, we will never find the truth. Embrace your negative thoughts or pain or what you don’t like. Challenge your belief at core (sub-conscious) level. That is your key, don’t ignore the call.
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Keep Chargin’. Be Awesome.
