The #1 Reason People Fail to Learn from Mistakes
How hindsight bias tricks you into thinking "you knew it all along"
“Hindsight bias makes surprises vanish. “
-Daniel Kahneman
They say hindsight is 20-20.
Hindsight feels like it’s 20-20, but in reality, it’s closer to a funhouse mirror, providing a distorted version of reality.
In this entry in the Money on my Mind series, I discuss how “hindsight bias” impacts financial decision-making.
What is hindsight bias?
Hindsight is when you see how an event turned out and falsely believe that “you knew all along” how things were going to unfold.
Think of the tortured NFL fan who spent the last three hours watching the game telling everyone around them how their team is going to win. But, when their team misses the deciding field goal and loses the game, they tell their friends, “I knew they would lose this game.”
That’s hindsight bias in action.
Once we know all the facts, our brains have a tendency to rewrite the past and make it seem like we knew how everything was going to play out.
Hindsight Bias prevents us from learning from our mistakes
A common piece of self-help advice is that we learn more from failure than we do from success.
To quote Yoda:
“The greatest teacher, failure is.”
A more accurate way to frame failure would be that failure can be our greatest teacher, but only if we can honestly and accurately identify the exact causes of failure.
That’s where hindsight bias gets in the way.
Imagine you started a business, and I ask if you if the business will survive its first year. You confidently reply, “yes.” Then in a year, I checked back in, and the business failed. I ask you to recall how you answered that question a year ago, and you tell me that you always had doubts about the business.
You are using the result—in this case, your business failing—to rewrite history and create a fictional narrative that you always knew what would happen.
That is exactly what a researcher from The University of Pennsylvania found in a 2009 study that asked entrepreneurs about the probability of their company succeeding and followed up with them a year later after their business failed and asked them to recall how they answered the question a year ago. The gap between how they actually answered the question on day one and how they recall answering it after the business failed can be attributed to hindsight bias.
The researchers point out that their failure to analyze why their business failed can lead to overconfidence and make it less likely that their next business venture will be successful.
How can you learn from failure if you’re not willing to do the necessary work to understand the truth about what mistakes you made?
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How it applies to investing
An obvious arena where failing to learn from past mistakes can cost you dearly is investing.
A 2009 study showed that even professional investors who work for investment banks allow hindsight bias to drag down their returns. More troubling was that years of experience did not reduce the impact of hindsight bias. 40-year vets and rookie bankers were just as likely to believe that “they knew it all along.”
The stock market is volatile, meaning prices can swing up and down in the blink of an eye. After a period of high volatility passes, investors—even pros—have a tendency to overestimate how well they did during these volatile periods. This causes overconfidence and leaves them unprepared to handle the next period of volatility.
After the 2008 financial crisis, seemingly every high-profile investor said one of two things;
We should have seen this coming
I did see this coming
Except very few people were warning us about the U.S. mortgage bubble before it popped.
But thanks to hindsight bias, many investors wrongly believe they saw the last crisis coming, which gives them unearned confidence in thinking they can correctly call the next crisis before it happens. So, they sell their investments in anticipation of a crash that never happens and miss out on future gains.
Overcoming hindsight bias
For investors, the more active you are in managing your portfolio—the more often you check your balance and make trades—the more likely you are to fall into the hindsight bias trap.
My investment plan is to buy a few globally diversified index funds and hold onto them until I retire. If I continue to stick with that plan of buying and never selling, I don’t need to worry about hindsight bias impacting my retirement fund.
That is not to say you shouldn’t worry about hindsight bias because not everyone agrees with the buy-and-hold strategy, and hindsight bias impacts more than just your investment decisions.
One suggestion I see consistently endorsed by psychologists is to consider keeping a “decision journal,” which allows you to keep notes about important decisions and detail why you made the decision you did and what you believed the final outcome would be.
Reviewing this history of your decisions can provide a much-needed reality check that you didn’t “know it all along,” which is the first step to learning from your failures and making better decisions in the future.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.