Recently, Lloyd Blankfein of Goldman highlighted an important feature of psychology that has impacts on financial markets: Hindsight Bias.
He is discussing whether we are in a bubble comparable to Tulip Mania. The key point he makes for our purposes today is:
“But, of course, you never really know until you know, he said. “When something happens, 80 percent of the world will remember knowing it … in hindsight.” ”
In psychology, this feature is known as Hindsight Bias. It means that people falsely believe that they predicted events that have now occurred. I suspect that this is due to another sort of idea much discussed in philosophy. The common idea of time seems to be modeled on a ‘moving block’ theory. This says that while the future is still open and fluid, the past is now fixed. The fixed block moves forward as time does. So, since the past is now fixed, it begins to look like everything that happened had to happen. And since it was inevitable, we must have predicted it, right?
Wrong. The canonical experiment on this asks people to assess the probability of events from a story of a war between two countries. The build up is described and people are asked to assess the probability of war breaking out. It is revealed that the story is in fact an actual description of the period leading up to a conflict between two Asian powers. Some months later, people decide that since it did in fact happen, they must have predicted it. They claim now that they gave a much higher estimate of probability than they actually did.
What does this mean in financial markets? A great deal. Think about what you are
likely to do now if you suffer from this bias, as everyone does. You will overestimate the probability that you gave to past events. Then, you will over-estimate the probability of your future forecasts being right. This will make you over-confident at the wrong times and will kill your market performance.