The Importance Of Hindsight Bias In Financial Markets

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.

I cover the importance of understanding the biases inherent in psychology in my new book The Psychology of Successful Trading

Hindsight Bias is just one of the many I discuss there.  There are two ways to benefit here in terms of improving your investment returns.  Firstly, you can look out for the biases in your own thinking and correct for them if need be. Secondly though, you can expect these biases to severely effect other market participants and that means opportunity for you.
You can take it from me since I have two relevant PhDs and spent nearly a decade on the trading floor of various investment banks.  Buy the book here:

The Psychology Of Successful Trading

 

 

Author: Tim Short

I went to Imperial College in 1988 for a BSc(hons) in Physics. I then went back to my hometown, Bristol, for a PhD in Particle Physics. This was written in 1992 on the ZEUS experiment which was located at the HERA accelerator in Hamburg (http://discovery.ucl.ac.uk/1354624/). I spent the next four years as a post-doc in Hamburg. I learned German and developed a fondness for the language and people. I spent a couple of years doing technical sales for a US computer company in Ireland. In 1997, I returned to London to become an investment banker, joining the legendary Principal Finance Group at Nomura. After a spell at Paribas, I moved to Credit Suisse First Boston. I specialized in securitization, leading over €9bn of transactions. My interest in philosophy began in 2006, when I read David Chalmers's "The Conscious Mind." My reaction, apart from fascination, was "he has to be wrong, but I can't see why"! I then became an undergraduate in Philosophy at UCL in 2007. In 2010, I was admitted to graduate school, also at UCL. I wrote my Master's on the topic of "Nietzsche on Memory" (http://discovery.ucl.ac.uk/1421265/). Also during this time, I published a popular article on Sherlock Holmes (http://discovery.ucl.ac.uk/1430371/2/194-1429-1-PB.pdf). I then began work on the Simulation Theory account of Theory of Mind. This led to my second PhD on philosophical aspects of that topic; this was awarded by UCL in March 2016 (http://discovery.ucl.ac.uk/1475972/ -- currently embargoed for copyright reasons). The psychological version of this work formed my book "Simulation Theory". My second book, "The Psychology Of Successful Trading: Behavioural Strategies For Profitability" is in production at Taylor and Francis and will be published in December 2017. It will discuss how cognitive biases affect investment decisions and how knowing this can make us better traders by understanding ourselves and other market participants more fully. I am currently drafting my third book, wherein I will return to more purely academic philosophical psychology, on "Theory of Mind in Abnormal Psychology." Education: I have five degrees, two in physics and three in philosophy. Areas of Research / Professional Expertise: Particle physics, Monte Carlo simulation, Nietzsche (especially psychological topics), phenomenology, Theory of Mind, Simulation Theory Personal Interests: I am a bit of an opera fanatic and I often attend wine tastings. I follow current affairs, especially in their economic aspect. I started as a beginner at the London Piano Institute in August 2015 and passed Grade Two in November 2017!

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