Hindsight Bias

1979 Energy Crisis

What is Hindsight bias?

Retrospective bias is a psychological phenomenon in which individuals tend to overestimate their own ability to predict an outcome that they could not have predicted before an event occurred. Retrospective bias can lead an individual to believe that an event was more predictable than it actually was and can result in an oversimplification of cause and effect. Retrospective bias is studied in behavioral economics.

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Behavioral finance

Understanding Hindsight bias

A posteriori bias is a fairly common phenomenon in investing, as pressure on the time of buying securities to maximize returns can often make investors regret not noticing trends earlier. For example, an investor may consider the sudden and unexpected death of a significant CEO as something that should have been expected since the CEO had serious health problems.

Key points to remember

  • Retrospective bias refers to a person’s tendency to believe that they could have accurately predicted a previous outcome, even if that person was unable to do so in real time.
  • This phenomenon has its origin in psychology but also plays a crucial role in behavioral economics.
  • By investing, retrospective bias can manifest itself in a feeling of frustration or regret at not having predicted a trend for a security or the market as a whole.

Financial bubbles are often subject to a large downward bias. After the Dot Com bubble in the late 1990s and the Great Recession of 2008, many experts and analysts have attempted to show how what appeared to be trivial events at the time was actually a harbinger of financial problems. future. If the financial bubble had been so obvious to the general population, it probably would have been avoided.

Investors should be careful when assessing how past events affect the current market, particularly when considering their own ability to predict how current events will affect the future performance of securities. Believing that one is able to predict future results can lead to overconfidence and overconfidence can lead to choosing actions not for their financial performance but for personal reasons.

Retrospective bias and intrinsic evaluation

As mentioned above, retrospective bias can distance investors from a more objective analysis of a company. Sticking to intrinsic valuation methods can help an analyst to ensure that he bases his investment decision on data-related factors and not on personal ones. Intrinsic value refers to the perception of the real value of a stock, based on all aspects of the business and may or may not coincide with the current market value.

Intrinsic assessment will generally take into account qualitative factors, such as a business model, corporate governance and the target market, as well as quantitative factors (for example, financial statement ratios and analyzes) in determining if the current market price is correct or if it is overvalued or undervalued. Analysts typically use the discounted cash flow (DCF) model to determine the intrinsic value of a business. The DCF will take into account the free cash flow and the weighted average cost of capital (WACC) of a company.

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