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B. Venkatesh

CONSIDER this: You are generating 20 per cent returns on your investment, thanks to the strong rally in the stock market. But suppose the market takes a U-turn and declines 15 per cent in the next three days. Would you kick yourself because the decline was inevitable and you knew it all along?

If you do, be assured that your behaviour is normal. Studies in behavioural finance term such an action as hindsight bias. What does it mean?

Hindsight bias is the behaviour we display when we review past events. We often claim that we knew it all along after an event occurs. This behaviour makes us think that any uncertain event is easily predictable, after the event has occurred!

Hindsight bias was first documented by Professor Baruch Fischhoff in 1975. The experiment divided the subjects into two groups. The first group was asked to predict the possibility of certain events happening. The second group was provided the actual outcome and then asked to predict the likelihood of the event if they had not received the information.

Sure enough, the second group that had information on the actual outcome assigned higher probability for predicting the event. Similar experiments show that we do indeed suffer from hindsight bias.

Those familiar with behavioural finance will recognise that hindsight bias is closely related to another concept — the anchoring effect (see `A mental short cut', which appeared in this column on December 26, 2004).

How does hindsight bias affect our investment decision? It makes us overconfident about the future because we think we can easily predict events. And that means we do not quite learn from past mistakes. That is why experts suggest that we maintain a journal detailing the reasons for our investment decisions.

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