How the Hindsight Bias Clouds Your Financial Decisions

Photograph by Menty Jamir

The choices we make on an everyday basis are influenced by several things — they reflect our perceptions, our previously made choices, and the consequences we’ve faced by making those choices. When the outcome works in our favour, we’re happy to take all the credit, often overlooking any initial apprehensions. But when the outcome is unfavourable, we tend to look for reasons beyond our control. Psychologists define this phenomenon as ‘hindsight bias’ — a term that addresses a peculiar cognitive error that some individuals display, which involves magnifying our abilities to foresee how a situation might play out.

In real-world financial scenarios, the hindsight bias is quite common — it’s seen when people focus more on their past wins and overlook their losses, overestimate their aptitude for financial decision-making, and end up taking excessive risks — thereby increasing their chances of undergoing a loss. To put it simply, the higher the degree of hindsight bias, the greater the possibility of misreading the aftermath of our money choices. For instance, an investor who possesses this bias might become overconfident and invest heavily in equity, or even limit themselves to a fixed number of asset classes that have previously yielded positive returns, irrespective of whether their portfolio aligns with such financial decisions or not. This in turn causes them to own riskier, more concentrated portfolios and lose out on the benefits of diversification.

A large part of the hindsight bias stems from our unwillingness to acknowledge our shortcomings and failures, which leads to an imperfect recollection of losses or gains, and ultimately, an inability to learn from past mistakes. Since the bias deludes us into thinking that we can accurately predict the outcome of a financial decision, it also obstructs us from taking preventive or corrective measures to minimise risks and losses. If, say, an individual invests in real estate and earns high gains during a certain period of time, they might think of themselves as successful in predicting returns, and invest more in the sector. However, in the event of a market downturn, the value of the investment will deplete, which could lead to a liquidity crisis and financial distress.

Interestingly, certain personality types are more inclined to have a hindsight bias. As per MoneySign® — 1 Finance’s assessment framework that is designed to identify an individual’s financial traits and tendencies in order to bring them a step closer to financial well-being — people who fall under the profiles of Opportunistic Lion, Far-Sighted Eagle or Stealthy Shark are prone to hindsight bias. While these individuals do have several strengths when it comes to the way they handle money, the lack of a strategic and disciplined approach towards money management might lead them to attribute successes to their own faculties but blame failures on external factors.

One way to confront the bias is to become aware of how emotions and cognition influence our money choices, by studying universal examples of the mistakes people make. Consulting qualified financial advisors who adopt a holistic approach towards planning and managing personal finances, and offer an unbiased perspective, would also help navigate this roadblock effectively. On a personal level, documenting the performance of your investments is a great way to keep track of — and refer back to — the outcome of your financial decisions and the rationale behind them.

While it’s safe to classify hindsight bias as a behavioural shortcoming, the good news is that it isn’t entirely rigid or irreversible. Animesh Hardia, Senior Vice President of Quantitative Research at 1 Finance, says, “Education is the most critical aspect to correcting hindsight bias and being able to relate it with yourself. Look at your history in an unbiased way — with both the good and the bad — and try to recall why you made that decision. If you’re not honest with yourself, you’ll not be able to realise the fruit of correcting yourself in the future.”