Hindsight bias: why every crash looks obvious afterwards
Ask anyone today whether the dot-com bubble was obvious and they will say yes. Companies with no profits, and sometimes barely any revenue, were valued like national industries. A pet supplies website ran a Super Bowl advert and then went out of business within the year. Of course it was a bubble. Ask the same question about the 2008 housing crash and you get the same answer: banks were lending to people who could not repay, packaging the loans into securities and rating them as safe. How did nobody see it?
The uncomfortable answer is that many people did see pieces of it, most people did not act on it, and the ones who acted too early often lost money or their jobs before they were proven right. What feels obvious now was, at the time, one possibility among many. The psychological habit of forgetting that is called hindsight bias, and it is one of the most expensive mental errors an investor can make.
The "I knew it all along" effect
Hindsight bias was studied carefully by the psychologist Baruch Fischhoff in the 1970s. In one well-known experiment, conducted with Ruth Beyth, people were asked before President Nixon's 1972 trips to China and the Soviet Union how likely various outcomes were. After the trips, the same people were asked to recall what they had predicted. They systematically remembered having assigned higher probabilities to the things that actually happened than they really had. Fischhoff called this "creeping determinism": once we know how a story ends, the ending starts to feel inevitable, and our memory quietly edits our past uncertainty out of the record.
In everyday life this is mostly harmless. In investing it is corrosive, for two reasons. First, it makes us overconfident: if we believe we saw the last crash coming, we assume we will see the next one. Second, it teaches the wrong lessons: we conclude that the signal was clear and we were merely careless, rather than that the future was genuinely uncertain and remains so.
Being right too early looks exactly like being wrong
The clearest illustration is the dot-com era itself. In December 1996, Federal Reserve chairman Alan Greenspan gave a speech in which he asked how we would know when "irrational exuberance" had unduly escalated asset values. Markets wobbled the next day. Then they carried on rising for more than three years. The Nasdaq did not peak until March 2000, by which point it had multiplied several times over since Greenspan's remark. Anyone who sold in alarm in late 1996 was right about the destination and badly wrong about the journey.
The same pattern appears in the housing bubble. A handful of investors who bet against mortgage securities before 2008 later became famous, but several of them endured long periods of losses, angry clients and redemption requests before the trade paid off. For every one of them, there were others who made similar arguments, ran out of money or patience, and are now forgotten. There is a line often attributed to John Maynard Keynes, that the market can stay irrational longer than you can stay solvent. There is no solid record that Keynes actually said it, but the idea is sound regardless of its author.
Hindsight compresses all of this. It removes the years of waiting, the false alarms, and the many credible people predicting the opposite. It leaves only the crash and the few voices that, in retrospect, called it.
The signals that seemed reassuring at the time
It is also worth remembering how strong the case for optimism looked before each collapse. Enron was named "America's Most Innovative Company" by Fortune magazine six years in a row, up to and including 2001, the year it went bankrupt. Lehman Brothers was a 158-year-old institution with a long history of surviving crises. Wirecard was a member of Germany's DAX index, sitting alongside the country's largest industrial names, when it admitted that €1.9 billion supposedly on its balance sheet probably did not exist.
The warning signs existed in each case. There were short sellers, sceptical journalists and awkward questions about cash flows. But there were also auditors, ratings agencies, analysts and regulators offering reassurance. In real time, the investor has to weigh both sets of voices without knowing which will be vindicated. Hindsight hands you the answer key and then asks why you found the exam difficult.
Outcome bias: judging decisions by results
A close cousin of hindsight bias is outcome bias: judging a decision purely by how it turned out. If someone put their savings into a single cryptocurrency in 2015 and became rich, it is tempting to call it a brilliant decision. If someone did the same with a different token that collapsed, we call it reckless. Often, though, the two decisions were made with similar information and similar reasoning. One person was lucky.
A more useful way to judge a decision is to ask what was knowable at the time, what the range of possible outcomes looked like, and whether the size of the bet was sensible given that range. A good decision can produce a bad outcome, and a bad decision can produce a wonderful one. Over many decisions, good process tends to win, but any single result tells you surprisingly little.
How to defend yourself against it
- Write things down before you know the answer. A short note explaining why you are making an investment, and what would make you wrong, is the only reliable antidote to a memory that edits itself.
- Look for the people who were right too early. When you read about someone who called a crash, ask when they first called it, and what happened to anyone who followed their advice on that date.
- Count the forgotten forecasts. For every famous correct prediction there were many confident wrong ones. Nobody writes books about those.
- Size positions for uncertainty. If you cannot be sure, and you rarely can, avoid any single bet large enough to ruin you if you are wrong.
- Be suspicious of your own certainty about the next crash. If the last one feels obvious in hindsight, the next one will probably not feel obvious in advance.
Hindsight is the whole premise of Sixty-40
Sixty-40 is, quite deliberately, a game played with the answer key in your hand. You know how Pets.com ended and how Amazon did, so picking well should be easy. And yet, with ten seconds on the clock and five plausible names in front of you, it is surprisingly easy to talk yourself into the wrong one, or to pass over a winner whose story you never knew. If investing with perfect hindsight is that tricky, it is worth some humility about investing without it.