The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails

Illusions

Many people think they know something, when they really don’t. The behaviorists call this hindsight bias. When people are presented with new information, they think that they knew it all along. A 2008 study of bankers in London and Frankfurt found that this condition causes people—even professionals—to inaccurately estimate asset returns, which leads to bad trades and portfolio performance, and to even underestimate volatility, which leads to ineffective use of risk reduction strategies.25

Hindsight bias is a serious problem when combined with overconfidence, particularly for well-educated, successful professionals. Bruno Biais and Martin Weber decided to test a group of 85 bankers in London and Frankfurt to see how they were impacted by hindsight bias. They found that bankers who made the most money had the lowest bias. This reinforces the idea that hindsight bias is a trait that influences people’s behavior and prevents them from rationally processing information and learning from the past.

Biais and Weber, of Toulouse University and the University Mannheim, respectively, wrote in a study of hindsight bias:

In financial markets the inability to be surprised, to learn from the past and to reject hypotheses can be very damaging. Hindsight biased traders will fail to recognize that their view of the market was wrong. Hence they will fail to cut their losses when it is optimal to do so. Hindsight biased investors will inaccurately take into account the informational content ...