Perfect hindsight is not the same as perfect understanding. When evaluating past decisions, people can often become too fixated on the actual unfolding of events, treating these past events as more predictable than they really were by back-fitting explanations. This natural tendency can lead to a host of biases which can be counter-productive to treasury risk management.
For example, as discussed last month (see Treasurers, how overconfident are you?), an overconfidence in the predictability of events may lead to more speculative decisions than those primarily aimed at risk reduction. In this article, we introduce two more common biases that can often hinder rational decision making.
Factor 1: “Hindsight Bias” – The Delusion of Randomness
Consider this example as quoted on “Thinking, Fast and Slow by Daniel Kahneman.”
On December 13th, 2003, former Iraqi dictator Saddam Hussein was captured and Bloomberg News blared the headline, “U.S. TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM.” Thirty minutes later, bond prices retreated and Bloomberg altered their headline: “U.S. TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.”
Daniel Kahneman1, the renowned behavioral scientist, notes “A statement that could explain two contradictory outcomes explains nothing at all”.
Yet, we as humans need explanations of causations even for events that are down to pure luck and randomness. Headlines, or a story that could help us explain past events, can satisfy our need for coherence.
However, they could also fool us into believing that past events are more predictable than they actually are, a well-known psychological phenomenon called the “hindsight bias.”
Factor 2: “Halo Effect” – The Wrong Attributions
Similarly, when a company is doing well, with rising sales, higher profits and a sharply increasing stock price, the tendency is to infer that the company has a sound strategy, a visionary leader, motivated employees, and so on. But when that same company suffers a decline, we can be quick to conclude that the company’s strategy went wrong, potentially blaming its people and more. In fact, these things may not have changed much, if at all.
The human tendency to seek coherence to construct a story in our mind and our potential failure to acknowledge random factors, can give rise to another famous psychological phenomenon known as the “halo effect.”
(See McKinsey’s article on the Halo Effect and other managerial delusions.)
Implications for Hedging Policy
Both effects above stem from our need to construct stories to make sense of the world.
Therefore, seasoned and experienced treasurers are not those who have made more right calls than wrong calls, but those who have risen above the temptation to succumb to the belief that markets are predictable, and have the humility to acknowledge there is a high degree of randomness and uncertainty within markets beyond anyone’s control.
Companies also need to be wary of the halo effect so that decisions are evaluated based not on outcomes, rather on the quality of the decision making process itself.
Defining the right hedging strategies can be a complex journey. That’s why the HSBC Thought Leadership team has put together a dedicated team of experts to help corporates assess and implement a hedging programme suitable to their needs.
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Next month, we will look how optimal strategies are arrived at with a simple example of counting words in a book and what they mean for hedge optimisations.
Find out more markets insights in our New Future series.
1 Daniel Kahneman was awarded the 2002 Nobel Memorial Prize in Economic Sciences (shared with Vernon L. Smith)
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