Hindsight Bias and Investment Performance

Once they have observed information, hindsight biased agents fail to remember how ignorant they were initially. This bias has been amply documented by the psychological literature. To study its economic consequences, we formulate a theoretical model of the hindsight bias, providing a foundation for previous empirical measures. We show theoretically that hindsight biased agents overreact to information signals, conduct incorrect learning about volatility, and engage in suboptimal investment decisions. To test empirically the hypothesis that the hindsight bias reduces performance in important economic situations, we collect psychometric and performance data from a sample of investment bankers in London and Frankfurt. We find strong evidence that these agents are hindsight biased, and that more biased agents have lower performance. These findings are robust to differences in location, information and experience. Many thanks for thoughtful comments to participants in the Toulouse and Amsterdam Universities seminars, the Warwick Conference on Behavioral Finance (2006) and the Munich Summer School on Economics and Psychology (2006), in particular Denis Hilton, Luis Garicano, Robin Hogarth, Florencio Lopez de Silanes, Thomas Mariotti, Paola sapienza, Jean Tirole and Luigi Zingales.

[1]  A. Tesser,et al.  Motivational interpretations of hindsight bias: An individual difference analysis , 1983 .

[2]  Colin Camerer.  Do Biases in Probability Judgment Matter in Markets? Experimental Evidence , 1987 .

[3]  John A. List,et al.  Do professional traders exhibit myopic loss aversion? An experimental analysis , 2005 .

[4]  Reid Hastie,et al.  Hindsight and Causality , 1991 .

[5]  Markus Glaser,et al.  Overconfidence and trading volume , 2003 .

[6]  B. Fischhoff,et al.  Hindsight ≠ foresight: the effect of outcome knowledge on judgment under uncertainty* , 2003 .

[7]  Erich Kirchler,et al.  Hindsight bias in economic expectations: I knew all along what I want to hear. , 2002, The Journal of applied psychology.

[8]  Linda L. Carli.  Cognitive Reconstruction, Hindsight, and Reactions to Victims and Perpetrators , 1999 .

[9]  Kent D. Daniel,et al.  Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions' , 1998 .

[10]  B. Fischhoff,et al.  I knew it would happen: Remembered probabilities of once—future things , 1975 .

[11]  Emma Soane,et al.  The individual and contextual influences on the market behaviour of finance professionals , 1999 .

[12]  Neal J. Roese,et al.  Twisted Pair: Counterfactual Thinking and the Hindsight Bias , 2008 .

[13]  J. List.  Does market experience eliminate market anomalies , 2003 .

[14]  George Loewenstein,et al.  The Curse of Knowledge in Economic Settings: An Experimental Analysis , 1989, Journal of Political Economy.

[15]  Baruch Fischhoff,et al.  Judgment under uncertainty: For those condemned to study the past: Heuristics and biases in hindsight , 1982 .

[16]  D. Hirshleifer.  Investor Psychology and Asset Pricing , 2001 .

[17]  M. Rabin.  Psychology and Economics , 1997 .

[18]  Morten I. Lau,et al.  Estimating Individual Discount Rates in Denmark: A Field Experiment , 2002 .

[19]  Bruno Biais,et al.  Judgmental Overconfidence, Self-Monitoring and Trading Performance in an Experimental Financial Market , 2005 .

[20]  Terry Connolly,et al.  Hindsight Bias and Strategic Choice: Some Problems in Learning From Experience , 1988 .

[21]  M. Rabin.  Inference by Believers in the Law of Small Numbers , 2000 .

[22]  J. Baron,et al.  Outcome bias in decision evaluation. , 1988, Journal of personality and social psychology.