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.

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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

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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.

See Also:

The Psychology of Successful Trading: see clip below of me explaining my new book!

#Narcissism and #Unexpected Behaviour

The Illusory Truth Effect And Financial Markets

Sherlock Holmes as Enemy of Confirmation Bias

 

 

Author: Tim Short

I am a former investment banking and securitisation specialist, having spent nearly a decade on the trading floor of several international investment banks. Throughout my career, I worked closely with syndicate/traders in order to establish the types of paper which would trade well and gained significant and broad experience in financial markets. Many people have trading experience similar to the above. What marks me out is what I did next. I decided to pursue my interest in philosophy at Doctoral level, specialising in the psychology of how we predict and explain the behaviour of others, and in particular, the errors or biases we are prone to in that process. I have used my experience to write The Psychology of Successful Trading. In this book, I combine the above experience and knowledge to show how biases can lead to inaccurate predictions of the behaviour of other market participants, and how remedying those biases can lead to better predictions and major profits. Learn more on the About Me page.

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