BIAS 7 HINDSIGHT BIAS BIAS DESCRIPTION Hindsight bias

BIAS #7 HINDSIGHT BIAS

BIAS DESCRIPTION Hindsight bias is the impulse that insists: “I knew it all along!” n n n Once an event has elapsed, people tend to perceive that the event was predictable—even if it wasn’t. People tend to overestimate the accuracy of their own predictions. This is not to say, that people cannot make accurate predictions. Reason of the hindsighnt bias n n Actual outcomes are more readily grasped by people’s minds than the infinite array of outcomes that could have but didn’t materialize. Unpredictable developments bother people, since it’s always embarrassing to be caught off guard. Hindsight bias alleviates embarrassment, blunting the ugliest of surprises. Hindsight bias. . from politics to medicine.

BIAS DESCRIPTION Hindsight bias is the tendency of people, with the benefit of hindsight following an event, to falsely believe that they predicted the outcome of that event in the beginning. n Hindsight bias affects future forecasting. n n A person assumes that the outcome he or she ultimately observes is, in fact, the only outcome that was ever possible. Thus, underestimates the uncertainty preceding the event. n Baruch Fischoff’s experiment n He asked subjects to answer general knowledge questions from almanacs and encyclopedias. n Later, after revealing the correct answers, Fischoff asked his subjects to recall their original responses from memory. n The results are revealing: In general, people overestimated the quality of their initial knowledge and forgot their initial errors. n DENEYİ BULALIM,

BIAS DESCRIPTION Hindsight bias is a serious problem for market followers. n Once an event is part of history, there is a tendency to see the sequence that led up to it, making the event appear inevitable. n n Outcomes exert irresistible pressure on their own interpretations. Blunders with happy results are described as brilliant tactical moves, and unfortunate results are described as avoidable blunders. n Hindsight bias is that it can prevent learning from mistakes. n People find it difficult to reconstruct an unbiased state of mind. n It is easier to argue for the inevitability of a reported outcome. n In sum, hindsight bias leads people to exaggerate the quality of their foresight.

PRACTICAL APPLICATION n People fool themselves into thinking that they could have predicted the outcome of some financial gamble, but they achieve such crystal-clear insight only after the fact. n n n Nobody views the soaring market indexes as symptomatic of a short-lived “bubble”. During 1990 s bull even some of the most sophisticated investors said: “It’s different this time!” Chatting with most investors today, you’ll get the impression that they were not fooled by the “irrational exuberance”. Often, people insist that the collapse of late-1990 s prosperity was “clearly in the cards, ” or they comment: “Wasn’t it obvious that we were in a bubble? ” n Giving in to hindsight bias can be very destructive, because it leads investors to believe that they have better predictive powers than they actually do. Relying on these “powers” can invite poor decision making in the future.

IMPLICATIONS FOR INVESTORS n The biggest implication for investors is that hindsight bias gives investors a false sense of security when making investment decisions. This can manifest itself in excessive risk taking behavior, and place people’s portfolios at risk. 1. When an investment appreciates, hindsight-biased investors 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 investors begin to believe that they have superior predictive powers. 2. Hindsight-biased investors also “rewrite history” and block out recollections of incorrect forecasts in order to alleviate embarrassment. This form of self deception, in some ways similar to cognitive dissonance, prevents investors from learning from their mistakes. Most prefer not recognize that the speculative frenzy clouded their judgments.

IMPLICATIONS FOR INVESTORS 3. Investors can fault their money managers when funds perform poorly. Looking back, these investors perceive every development as inevitable. How, then, could a manager be caught by surprise? n n In fact, even top-quartile managers who implement their strategies correctly may not succeed in every market cycle. Managers of small-cap value funds in the late 1990 s, for example, drew a lot of criticism. However, these people weren’t poor managers; their style was simply out of favor at the time. 4. Conversely, hindsight bias can cause investors to unduly praise their money managers when funds perform well. n n The hindsight obscures the possibility that a manager’s strategy might simply have benefited from good timing or good fortune. Consider the wisdom attributed to managers of aggressive growth tech funds in the late 1990 s.

RESEARCH REVIEW n Cooper , Gutierrez and Marcums’ paper entitled “On the Predictability of Stock Returns in Real Time, n Research discusses hindsight bias in the context of fund manager selection and argues that some money manager’s track records are unduly criticized due to hindsight bias. n n n Money managers with long track records might be ordinately blamed for not outperforming a certain strategy that “worked” over a given time period. This happens when the researchers are comparing the manager’s track record to a strategy that has only recently been recognized as an accepted size or style strategy. They demonstrate a marked difference between ex post and ex ante predictability, suggesting that the current notion of predictability in the literature is exaggerated.

RESEARCH REVIEW n Cooper, Gutierrez, and Marcum argued implicitly that since true value indexes weren’t created until after 1992, the managers are being unduly criticized. n n n The money manager would have no reason in 1980 to think that low price-to-book ratio stocks would outperform the market because that was not a recognized strategy. Thus, this manager’s track record should only be compared to a value index from 1992 to 2005 rather than from 1980 to 2005. Before you criticize a fund manager’s track record for any given asset class, make sure you know when his or her strategy gained popularity. Judge the track record from there.

ADVICE n “Rewriting History”—Predicting Gains. n When a client overestimates the degree to which some positive investment outcome was foreseeable, the best course of action is to gently point to the facts. n Storytelling is a strategy that might help communicate your point without offending the client. n You might make reference, for example, to the collapse of the tech bubble in the 2000– 2002 period. A cautionary tale can highlight the pitfalls of overestimating one’s own predictive powers. n “Rewriting History”—Predicting Losses. n Advisors need to recognize that many people prefer to block recollections of poor investment decisions. n Understanding why investments go awry, however, is critical. n Counsel clients to carefully examine their investment decisions, both good and bad. Encourage self-examination. This will help eliminate repeats of past investment mistakes.

ADVICE n Unduly Criticizing Money Managers for Poor Performance. n Clients need to understand that n n n A manager is hired to do a job, and that job is to implement a defined investment strategy. A good manager adheres to a consistent, valid style, through good times and bad. Markets move in cycles and that, at certain times, an investment manager will underperform in his or her class, relative to other asset classes. Just because many growth managers underperformed in the early 2000 s, when values of many stocks were in a downward cycle, does not mean that growth managers are categorically unskilled. Education is critical here.

ADVICE n Unduly Praising a Money Manager for Good Performance. n The same line of reasoning n There are plenty of investment managers who benefit circumstantially from market cycles and still do not meet benchmarks. These are the managers to avoid. n Again, education is critical; once clients understand the role that a manager plays in determining fund performance, hindsight bias can be curtailed.