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How Flawed Hindsight Can Breed Overconfidence

by Roy Brindley |  Published: Aug 01, 2010

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Of the horses you have backed and lost a substantial sum on how many of their names can you recall? How many of those that won can you remember? My guess is a fair few of the latter and very few of the former. Yet you have probably backed far more losers than winners. You only recall the big winners. The reason? Selective memory, the way we remember things.

Our memories are shaped to a great extent by the present and we frame the past using this knowledge. The implications for our experiences of investing in a horse, greyhound, or football team is fascinating.

According to a recent paper by a Zurich-based firm of financial analyists, flaws of memory impair our ability to learn from the past and contribute to our poor financial decision making.

The report states bad memories tend to be blocked out by good ones. Just as we find it easier to remember the types of bet on which we have won money, we block out our poor financial decisions with other memories that are more pleasant for us. This conditions us to become overconfident.

Another memory flaw gives rise to what is termed “hindsight bias”. This is the tendency to look back and see events as being more predictable than they were before they took place.

Take Newcastle winning the English football Championship this past season. It is difficult to disentangle ourselves from the belief that this was a formality — when viewed through the lens of what we now know. To some it’s almost as if uncertainty and chance did not exist at the start of the season.

I have learned the dangers of hindsight bias the hard way. It promotes overconfidence by fostering the illusion that the world is a far more predictable place than it is in reality.

This gives gravity to the process of diary-keeping whereby our bets and the grounds for them, the thought process, are logged. These writings will allow us to learn from previous mistakes. It will be harder for you to convince yourself that you knew something all along when you are faced with the evidence of how events unfolded at the time.

In his annual letter to his shareholders Warren Buffett, the most successful financial investor in the world, delivers an investment diary of sorts indicating there is a casual link between his ability to learn from history and his success.

Cognitively, we get smarter through the generations, but not emotionally. Investment decision-making, be it poker or conventional gambling and trading is invariably an emotional process and so learning to master one’s emotions is one of the most valuable things we can learn to do. Spade Suit

Sir John Hall Stand