It’s no secret that trading will be one of the hardest endeavors you will ever attempt. What makes it so difficult is not that the system is rigged against you, or anything external. Most of the issues all lie within your self.
Hindsight bias is one of the most common psychological issues that stop traders from objectively viewing their trading results, and figuring out methods to improve them. In order to become a consistently profitable trader, you have to learn how to combat this psychological issue that you will face on a daily basis. Let’s start by defining exactly what hindsight bias is:
What is Hindsight Bias?
The textbook definition of hindsight bias is the psychological of people to overestimate their ability to have predicted an outcome that could not possibly have been predicted. This is a phenomenon witnessed in trading on a regular basis. It is one of the most common reasons why traders cannot improve their trading results.
Perceiving Your Trades in the Now
In trading, everything seems obvious hindsight. “If I held and sold there I would’ve made 10 grand.” “If I bought there I would’ve caught the whole move”. “That was a short not a long”.
It is easy to go back and look at a trade and say “I should’ve bought lower” because the stock traded lower than your entry for a period of time. It is also easy to say “ I should’ve sold higher” when the stock kept trading higher. But was it so obvious that you bought too low or sold to high at that moment? Would you be saying you did something wrong if the stock went in your favor?
Hindsight Analysis
In mainstream finance, hindsight analysis is pretty much the norm. When Facebook’s stock goes up, analysts say its cause of its great fundamentals. When it goes down, they say its because of trade war concerns weighing down the overall market (or whatever major geopolitical issue is going on in that moment).
Hindsight analysis tells you nothing about how you could capitalize on a similar opportunity in the future. It is easy to seem like a genius in the markets by talking in hindsight. But you won’t be able to actually make money from the markets until you learn how to capitalize on opportunities BEFORE the stock makes a move.
Playing Probabilities
In order to overcome hindsight bias, you have to think in terms of probabilities. The correct trading decisions are actually not based on what happened after you made the decision to buy or not buy (or short or not short). It is based on the probability of what was happening at THAT moment. A stock goes in any direction at any given moment. What happened after does not validate your decision.
Even on a setup you have a 70% win rate (and a solid risk vs reward on), there is still a 30% chance of it failing. Once a stock gives you a setup that you KNOW makes you money in the long run, it is your duty to be in the stock no matter what. What happens after you enter doesn’t matter. Even if the stock fails and you lose money, you did the right thing.
CEI Example
Here’s an example, but in the opposite scenario described above: You decided to trade $CEI yesterday, and you bought it at $8 and sold at $9:
You made money, but did you make a high probability decision? The answer is no. Most of the time a penny stock that is up almost 300% will not follow through to the long side.
In hindsight, it looks like you made the correct decision because you made money. But in trading, the correct decision isn’t determined by the outcome of 1 trade. 9/10 times buying penny stock up 300% on the day will not work.
What happened after your decision did not determine whether you made the correct decision or not. Winning traders don’t let what happens after they enter or exit affect what they do on the next trade.
You cannot let hindsight bias determine whether a trading decision was correct or not. You need to backtest and have data to assign a probability to any given scenario in trading. Don’t let other traders on Twitter and analysts fool you with hindsight analysis.
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