The Hindsight Bias: Cause and Effect

“Hindsight is a wonderful thing.” Whenever someone utters this sentence, he or she most likely wishes that he or she had known better in the past. You may think that this simple phenomenon is common knowledge, but I bet that you’re in for a surprise as you read on to realise the level of complexity of this phenomenon. After reading this article, you would be able to understand why it is seldom possible to know the better of something in the past. You would then go on to appreciate how remarkably susceptible we are as human beings to commit mistakes as a result of the hindsight bias (and how often mistakes indeed occur). Finally, you’ll get insights into how you can best utilise the knowledge of the hindsight bias to your benefit in real life applications.

Cause:

As human beings, we have a limited attention span, and a very efficient memory system to get the most out of each memory strand. This combination leads us to divert our focus to the most important memories from the past that are likely to serve us best in the present. The problem occurs when our emotions attached to these memories tend to rewrite these memories (essentially altering the past) in order to reaffirm the most plausible narrative that explains our present actions.

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A fictional illustration of this phenomenon:

Let’s say that you are a proud human being, who thinks that he or she is attractive, smart, elegant, intelligent, etc., and this happens to be your present day narrative. One fine day, your friends come over to your place for a grand dinner to celebrate your most recent success at work, and all of a sudden, your mother decides to fetch your old school photograph from your teenage years and displays it proudly to you and your friends. You are totally embarrassed by your appearance in the photograph; your choice of fashion back then appears to be poor now; that nervous smile gives away your past insecurities; and let’s not even get started on that god-forsaken hairstyle of yours back then. Your friends, on the contrary, find the photograph interesting. But you .. you wish you were hiding inside a closet, and are mad at your mother at the same time. You actually don’t wish to believe that it was you back then, as it does not align with your present day narrative (where you are the enigmatic hero or heroine of your life). After this little “incident”, you quickly forget that it ever happened (actually the memory gets pushed down to the lowest priorities of your memory-system) so that you may function more efficiently in the present. But deep inside, you wish that you had known better back then, and presented yourself like the attractive, smart, elegant, and intelligent person that you are today.

Another fictional illustration of this phenomenon:

A smart techie had spent $2000 to purchase ₿10000 (Bitcoins) back in 2010 when each bitcoin cost just 20 cents. He had then sold all of the bitcoins he had bought in June, 2012 for a price of $5.27 each, netting a profit of $50,700 on his initial investment (that’s a 2,535% profit, before taxes). At the time of writing this article, one bitcoin trades at a price of $9,084. Had the techie held onto his initial investment, it would now be worth $90,840,000 (again, before taxes). He wishes that he had known better, but recites “Hindsight is a wonderful thing.” instead to deal with his emotions, and takes consolation in the fact that he had seen a handsome profit back in 2012 anyway, which he had eventually used as down payment for the house that he now lives in.

Effect:

To simplify, and express in a nutshell, the hindsight bias distorts our notion of rational thinking. We think we are making ‘cleverer’ rational decisions with the ‘experience’ of hindsight. But in reality, it is this very belief that makes the decisions less rational, and less ‘cleverer’.

In the first fictional illustration, you are likely to bear the perceived harsh experience from the past as regret, and if repressed, this decision spirals into other psychological complications that only hinder your future decisions, and does not help. In the second fictional illustration, the ‘smart’ techie is likely to believe that using this experience, he can make better investment decisions in the future. This misled belief is likely to lead him down a path of speculation under the pretense of rational decisions, ultimately spiraling down a dark path.

To explain this effect further, let us imagine that we have before us, a system with two possible outcomes: A and B. Let us also assume that at any given point of time, both A and B have an equal probability of occurring, and the outcome has to be unique (that is, either A or B, never both). Applying the mathematical notion of probability, the probability of occurrence of A is 0.5 (or 50%), and the probability of occurrence of B is 0.5 (or 50%). With this premise, let us now travel into the future, where the event has actually occurred, and it turns out to be ‘indeed’ A. Apart from the fact that we now feel that we always felt that A had a slight edge, we have also established that the ‘sure’ outcome of the system under consideration is A, and not B. Therefore, because of the way our memory and emotions function together as a system, we act as if the probability of occurrence of A is 1 (or 100%). But in reality, the probability of occurrence of A is, and was, and will be 0.5 (as per our initial assumption). This concept sounds very fundamental when it is expressed in this way, but it hurts me to say that I have come across mathematicians that make this blunder. Any mathematical trading model that employs heavy data mining to fit the algorithm tightly to the performance of the past course, and aims to predict the future is guilty of the very same mistake.

Conclusion:

The fundamental truth anchored in reality is that regardless of how much we understand the past, we do not have the ability to predict the events of the future with any certainty. The only exceptions to this conclusion are closed systems (where there are no explicit unknowns, and outcomes are quasi time-independent), and systemic outcomes (which are also are quasi time-independent). Consequently, hindisght is actually helpful with understanding closed systems and systemic outcomes. Below, you can find examples of such systems and outcomes. It is important to understand the distinction here to appreciate areas where hindsight bias is helpful, and where it is outright dangerous.

• Examples of closed systems (hindsight bias is helpful): Physics, Chemistry, Engineering, etc.,
• Examples of systemic outcomes (hindsight bias is helpful): Birth and death, cyclic stages – rise and fall, etc.
• Examples of areas where hindsight bias is dangerous: Socio-economic outcomes, political sciences, statistical predictions, etc.

It is also worth looking at the professions and entities that are likely to be susceptible to the hindsight bias, and professions and entities that are likely to exploit others using their counterparty’s hindsight bias.

• Professions and entities (list not exhaustive) susceptible to hindsight bias (because they think they know better):
  • Mathematicians
  • Engineers
  • Scientists
  • Economists
  • Doctors
  • Biologists
  • Governments

• Professions and entities (list not exhaustive) likely to exploit others using their counterparty’s hindsight bias (because they either think that they DON’T know better or they think that they know that their counterparty thinks that it knows better):
  • Insurance sellers
  • Stock brokers
  • Social media
  • Psychologists (also employed by social media)
  • Highly experienced derivative traders

To sum up, with all this knowledge:

• In the first fictional illustration, you would do well to accept your past, and embrace the thought that you are not perfect, and will never be, and it is unfair of you to subject yourself to your strict idealistic expectations. You will also never successfully predict how you will change in the future, and thereby, how your ideals will evolve in the future. You cannot cater to what you do not know. Therefore, there is no need for regret. Regret is not a good emotion to hold onto.
• In the second fictional illustration, the techie would do well to realise, and accept the fact that he got lucky with bitcoin, and that he could have also been unlucky in an alternate future where his $2000 ended as a wash-out (known in trader parlance as a Monte Carlo simulation). He would then go onto also realise that he knows absolutely nothing about future events, and would add due caution to his future investment decisions, which is more aligned with the notion of rational thinking.

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