Are we deluding ourselves?
Humans are fascinating, complex creatures, capable of amazing achievements. At the same time, as psychology researchers like Daniel Kahneman and Amos Tversky have pushed forward our understanding of the human mind, it has become increasingly clear that we are indeed strange. Far from being the rational decision makers that behavioural theory once assumed, we find that our cognitive processes can be deeply flawed, leading to poor decision making and sub-optimal outcomes.
As investors, it is helpful to have a working knowledge of some of the more prominent threats to orderly investment thinking. Indeed, many of the opportunities that exist in investment markets arise out of being able to exploit the poor decision-making of others.
One of my (least) favourite cognitive biases is hindsight bias: the tendency to view events after they have happened as much more predictable than they actually were before the event. When we become aware of an outcome of something – say an investment decision – we all have a tendency to reconstruct our memory with the benefit of the new knowledge (the outcome), such that we believe we knew – or perhaps should have known – all along what the outcome would be. The knowledge of the outcome can lead to the creation of new memories that are completely false, but very believable.
The concept of hindsight bias first emerged in the psychological research in the 1970s, and since then we have learned a few things about it, including:
- It is more likely to occur when the outcome of an event is negative. That stock call that you or your advisor got wrong – it turns out that that was especially easy to spot. Like a mile off;
- It is surprisingly resilient. Even people who are aware of it, and consciously trying to avoid it, suffer from it. Attempts to counter it have generally not been very successful;
- It is a particular problem for people who suffer from schizophrenia, and is associated with delusional belief, typically found in patients suffering from schizophrenia. However, this ability to delude ourselves is something we all share to some extent.
So, in answer to the question above, yes, we are all deluding ourselves, at least some of the time. Sometimes we have accomplices – the investment industry for example is replete with commentators who can explain (after the event) why said event was the inevitable consequence of what came before it.
For those that would be free of this particular bias, one method that has shown some promise is to take the time to explicitly think about the counterfactuals. If you actively think about the other things that could have happened but didn’t, you become less attached to the one thing that did happen.
Give it a try the next time you find yourself regretting an investment call that didn’t work out. Learn from your mistakes, by all means, but learn from the real ones, not the imaginary ones.