Totally addicted to Bias

I’ll admit that drum and bass is more a genre of music that my children appreciate, but it was either this or “a buttery biscuit bias” and even I couldn’t bring myself to go that far.

Bias, and mitigating it’s effects, has a big part to play in financial planning.

There are many types of bias that we deal with, and have to compensate for and try to remove where possible, for example:

• Recency Bias: the belief that something which has happened, will happen again soon (beloved of fund managers when they have a good year because they know it will bring in money over the next year, regardless of how well they perform);
• Survivorship Bias: where investment expertise may appear to exist, on the basis of data that ignores those investments that have failed along the way (very common when looking at tables of past performance);
• Confirmation Bias: where one pays most attention to information which confirms our belief, and ignores information which contradicts it.

One of the most interesting forms of bias though is Hindsight bias.

Hindsight as we all know is perfect, 20/20 vision and if we could only bottle it and turn it into foresight then everything would be great.

Hindsight Bias is more subtle and is the misconception that, looking back, one knew at the time what was going to happen.  This is the view that all the signs were there and everyone knew it was coming, and so did you if you think about it.  It then is either used to explain why you did something, or produces the belief that you could have done something about it if only you hadn’t been distracted by something else.

Hindsight Bias is particularly pernicious because it feeds into Overconfidence Bias; the belief that we are better than we are.

There have been numerous studies that have looked at this specifically in relation to investment (i.e studies in 2006 by Bhandari & Deaves; Hilary & Menzly; Statman, Thorley & Verkink) looking at both investment by private investors and investment professionals. For both private investors and investment professionals, short term successes fed the belief that these successes were due to individual skill, which then drove overconfidence in individual ability and an increase in trading and in risk taking as a result.

So when they looking back on what had happened, both professionals and non-professionals had their belief in their own ability reinforced; and, possibly not an expected result, but the more intelligent the person, the greater the belief that they knew all along what was going to happen.

What is particularly interesting is not just the way that Hindsight Bias persuades us that we have a special insight into the investment world and just need to start to act on our instincts, but also how we view differently the results of actual decisions that we have made.

The temptation to see decisions, that turn out to have correct short term impacts, as our ability to pick or time things, also creates the belief that decisions that turn out to have poor short term impacts, are just unlucky.  Reality however is that what turns out to be a good decision will probably have as much to do with luck as what turns out to be a bad decision, and where there are exceptions to this rule they are few and far between.

So accept that hindsight is perfect and foresight is flawed, but try to remember as many of the bad decisions as you do the good, and don’t be tempted to put good decisions down to skill and bad ones down to fortune.