Optimism Bias

The gist of optimism bias is often expressed by using the popular saying "rose-tinted glasses." In real life, it is helpful to be an optimist. Optimists often live happier and healthier lives. However, when it comes to financial markets, a healthy dose of skepticism is not only necessary but also recommended by many experts. In this article, we will have a look at what the optimism bias is as well as how it affects the decisions being made by investors.

What is Optimism Bias?

Optimism bias can be explained better by looking at the investors' core beliefs. Investors with optimism bias are aware that bad things can and do happen in the investment market. However, they are often of the opinion that these bad things cannot really happen to them. They implicitly believe that such bad things can only happen to others.

It is easy to see why this kind of thinking can be dangerous. If an investor truly believes that bad things cannot and will not happen to them, then they stop taking precautions. Since they disassociate themselves from the results of their actions, they often start making reckless decisions.

Investors who are afflicted with optimism bias often have an internal view of the markets. This means that they view the markets from their current financial and emotional situation. This is opposed to what the actual situation in the market is. A rational investor would make unbiased decisions based on market realities. However, optimism bias inhibits the ability of the investors to do so. It is important to realize the fact that such investors have optimism inbuilt in them. They are generally not unduly influenced by external situations. The reality is that they already had a certain feeling and that the rosy forecasts just confirm what they always believed to be true. It has been observed that even if such investors are presented with data that contradicts their views, they are simply likely to ignore it.

Difference Between Optimism Bias and Overconfidence Bias

Optimism bias, as well as overconfidence bias, are closely related. However, they are not the same. In the case of optimism bias, the investor is more hopeful that the outcome of the investment will be positive and in their favor. They may attribute this to luck or to a general sense of well being. However, when it comes to overconfidence bias, investors are likely to be hopeful of a better result because they believe that they have some expertise which the others do not have. Hence, anyone can be afflicted by the optimism bias, whereas on the other hand, when it comes to overconfidence bias, only investors who consider themselves to be experts are actually afflicted by the bias.

How Does Optimism Bias Impact Investment Decisions?

Optimism bias leads investors to place large unhedged bets. For instance, it is common for many employees to become too optimistic and then invest most of their personal retirement funds within the stocks of the company. This is because when people work at certain firms, they become overly optimistic about its outlook. Hence, they believe that such firms are less likely to suffer huge losses.

As mentioned above, optimism bias is closely linked to overconfidence bias. It gives the investor the feeling of having some sort of unique insight. It is this insight that makes them believe that they are more likely to succeed as compared to other investors.

Denial is another classic characteristic of optimism bias. People with this bias often tend to believe that they are beating the market. This belief is present, even if it is not true. There have been studies conducted which show that people with optimism belief actually tend to trail the market returns by at least five percentage points!

People with optimism bias tend to have a low savings rate. This is because people with this bias make high-risk investments. People with this bias also tend to have the personality type wherein the generally live beyond their means. Since a high savings rate is basically the benchmark for long term wealth, optimism bias has a negative impact on investment decisions.

How to Avoid the Optimism Bias?

Optimism bias is a type of irrational thinking. Hence, it is relatively easy to spot it and hence avoid it. Some of the ways to avoid the optimism bias have been mentioned in this article.

Reference Class Forecasting: Reference class forecasting is a technique that has been developed by Nobel Prize-winning psychologist Dr. Kahneman. As per this technique, the forecast that an investor uses should not be derived internally. Instead, it should be derived by looking at how a class of similar assets has performed over a similar time frame. Investors would do better if they were able to map a rough distribution of outcomes and use that data to map the returns on a new class of investment. It is a known fact that decisions that are made based on such outside views are more likely to produce an accurate forecast.

Compounding: Investors should be aware that compounding is the most significant contributor to their net worth. Hence, they should not rely on excessively flamboyant investments to earn good returns. Instead, they should stick with normal investments, which are more consistent in their returns, and let compounding happen over a number of years.

The bottom line is that optimism bias can have a detrimental effect on the portfolio of an investor, and hence, it should be avoided.