Over the last few weeks, I’ve written about several cognitive biases. Cognitive biases are mental shortcuts we all use, but if we’re not careful, they can lead us astray. This is undoubtedly the case when it comes to investing and the pitfalls of overconfidence bias and hindsight bias.
As the name implies, overconfidence bias involves having more confidence than one should objectively have in two general categories – the precision of one’s predictions, and the degree of certainty that one’s prediction is correct. An example of overestimating precision might involve estimating the range of value of a stock in a given period. The analyst subject to overconfidence might assume a gain or loss of no more than 15% in a given year even though history (and quite possibly post-prediction experience) shows a much wider range.
The second type of overconfidence bias is certainty overconfidence, and we see that when a group claims a higher level of confidence than subsequent experience demonstrates should have been the case. Numerous studies have shown that test takers answering factual questions stated they were a good deal more confident than the test results have shown they should have been. For example, test subjects might tell the researchers they are 90% certain each answer is right, while test scores average a good deal below 90%. Those of you who are teachers might well relate to this phenomenon.
As is the case with other biases, overconfidence bias is closely intertwined with and reinforced by other biases. Overconfidence works hand-in-hand with confirmation bias when one avoids or discounts information that runs counter to one’s decisions. For investors, overconfidence can lead to lack of diversification in a portfolio when the assumption is made that an investment can’t go wrong. As investors ourselves, maintaining genuinely diversified portfolios and making incremental changes only when valuations are extremely attractive or unattractive is key to avoiding overconfidence bias.
Another bias we use to comfort ourselves about the accuracy of our judgment is hindsight bias. This is the often erroneous belief that you “knew it all along” or more precisely, the conviction that you predicted the outcome of a particular event from the outset.
There have been many studies conducted to confirm hindsight bias, but an anecdotal example is probably most illustrative — the 2008 financial crisis. There seems to be no shortage of commentators in the press and on television who claim the fact that there would be a financial crisis was blindingly obvious – and the result should have been apparent to anyone paying attention.
While I’ll grant that the housing bubble was fairly obvious to anyone paying attention – (we wrote an article about outsized real estate returns in 2005) – what was not at all obvious were the repercussions of unwinding that bubble. Each of the knock-on effects – from the degree of exposure on the part of the banks to the destructive role of derivatives to the plummeting liquidity within the financial system were foreseen by a vanishing few.
One of the fundamental factors in hindsight bias is that after an event has occurred, we forget the possible number of outcomes that could have happened and the outcome that occurred becomes “obvious.” The problem with hindsight bias is that it leads investors to have more confidence in their decisions than they should have. In short, it feeds into overconfidence bias.
If you want to avoid overconfidence bias and hindsight bias, start with humility. Just knowing you are subject to these biases is helpful in and of itself. Beyond that, though, consider documenting in real time your key decisions and the beliefs that drove those decisions. Doing so can provide the feedback you need to improve your decision making over time.