My dear Friends,

Most of us think we are prudent in how we make decisions. We weigh our options and make the best possible choice in any given situation. Really?

Did you know that people constantly underestimate the likelihood of something bad happening to them and overestimate the chances of positive events?

To me, this sort of perpetual optimism is questionable. This is probably why some consider me a sour puss.

But, let‘s be honest, how can this be sustainable in a world with so many ups and downs and plenty of unpredictabilities?

So, does optimism bias really make life easier- or can there be a negative impact on someone‘s financial well-being?

What is optimism bias

Optimism bias refers to our tendency to overestimate our likelihood of experiencing positive events and underestimate our likelihood of experiencing adverse events.

Basically, thinking positively is an evolutionary hallmark because it facilitates envisioning what is possible, allowing us to be courageous and innovative. But thinking positively and suffering from optimism bias are two different shoes.

The phenomenon is also often referred to as “the illusion of invulnerability,” “unrealistic optimism,” and a “personal fable.”

Being positive means understanding the risks, admitting possible failure, and making good choices. However, optimism bias leads to overestimating the likelihood of positive events and subsequently underestimating potentially negative ones.

There are large costs to optimism bias in our personal and professional lives. We assume that projects will be completed in shorter amounts of time than they actually are. We assume our relationships will last longer than they realistically might. We assume that we will make more money than others or think it is infinite.

Optimism bias can encourage risky behaviours by causing us to ignore the potential for an unwanted outcome.  It also can stop us from taking preventative measures, like buying insurance or using contraceptives.

Resistance in the face of reality

Without optimism, humankind would not have progressed and would probably still live in caves.

However, the root of optimism bias are two assumptions: first, we possess more positive traits than the average person; second, we control the world around us.

Optimism is the trait that allows us to try new, potentially tricky things because it provides us with a certain amount of confidence that doing so will go well. It also stops us from worrying over uncertainties, such as the future. 

Despite unexpected adverse events, positive outcomes tend to leave the biggest impression on our belief systems, and optimism bias is quick to take the upper hand.

This overabundance of optimism, however, can lead to an inadequate assessment of potential hazards.

While optimism bias occurs with equal prevalence across the global population, culture significantly influences how optimistic or pessimistic people consider themselves.

Recent studies show only 10% of people are considered bias-free. Yet, one in two people with optimism bias believe themselves to be bias-free, and another 10% believe in having pessimism bias.

“….our brains aren’t just stamped by the past. They are constantly being shaped by the future.”

Tali Sharot, Neuroscientist, University College, London

The optimism bias conundrum

Optimism bias is both a necessity and the Achilles’ heel of entrepreneurship. Starting your own business is a very forward-looking action; consequently, you open yourself up to quite a bit of uncertainty. Optimism is highest when starting a business because the fate of the business is in your hands.

The reality, however, is most entrepreneurs don’t do well. In fact, only very few are, statistically speaking, very successful.

Yet almost 70% of new business owners use their own money to start the venture, so overestimating one‘s luck can negatively impact personal finances. Statistics show the return on investment in starting a business is just as good or bad as opting for high-risk investments in the stock market.

The Good

Being passionate about something makes you think you’ll be more successful than expected, and you, therefore, put a lot of time and effort into achieving your goals.

Tali Sharot, a neuroscientist from University College London, claims this kind of “cognitive illusion” is an inevitable and valuable feature of the human experience because:

Whatever happens, whether you succeed or you fail, people with optmism bias always feel better.

The Bad

Usually, when we evaluate our risks, we compare our situation to that of others. However, in the case of optimism bias, we are more egocentric. We focus on ourselves instead of realistically comparing ourselves to others. In short, it’s the egotistical belief that we’re better than we actually are

Optimism bias increases the belief that good things will happen in your life no matter what, but it may also lead to poor decision-making because you’re not worried about risks.

Optimism bias changes the objective reality, a bit like a self-fulfilling prophecy. So, as long as we are aware of our optimism biases, we can protect our actions from harm. However, this should not ruin the optimism that we often need.

“I knew that no matter how confident I was in making any single bet, that I could still be wrong.”

Ray dalio, Founder of Bridgewater&Associates

Optimism bias in finance and investing

Understanding where the markets are going is one of the most important skills in finance and investing. Especially if we have assets under management, we should always analyse what fund managers propose, or analysts say first.

Did you know that some 74% of fund/wealth managers consider themselves above average in their ability, and most market analysts consider themselves to be above average in their analytical skills?

Frankly, this is a statistical impossibility as it can not be that either most analysts or fund managers are above the average. So better ask questions than to be sorry!

Types of optimism bias:

1. Over-Ranking: Over-ranking is when someone rates their own personal performance as higher than it actually is.  The reality is that most people think of themselves as better than average. This can cause significant problems in business and investing because it typically leads to taking on too much risk.
2. Illusion of Control occurs when people think they have control over a situation when they do not. This can be very dangerous in business or investing, as it leads us to think situations are less risky than they actually are. Failure to assess risk accurately leads to failure to manage risk adequately.
3. Timing Optimism: As much as overestimating how quickly some tasks get done, especially complicated tasks, investors frequently underestimate how long it may take for an investment to pay off.
4. Desirability Effect: The desirability effect is when people overestimate the odds of something happening simply because the outcome is desirable- wishful thinking. In fact, this belongs to the optimism bias spectrum. We make the mistake of believing that an outcome is more probable only because that’s the outcome we want.

Fear of being wrong

While optimism is considered a strength in many situations, in investing, it can also be a weakness. Careful risk management is critical to successful investing. So, being mistakenly over-optimistic in investment decisions interferes with our ability to practice good risk management. Optimism bias often leads us to view our investment decisions as less risky than they actually are.

A good example is the recent collapse of FTX and Alameda. Thousands of retail and a handful of institutional investors believed cryptocurrencies were on a continuous upward trajectory and preferred to believe what the founders told them. Investors paid a high price for their optimism bias when the cryptocurrency exchange filed for bankruptcy in November. Alameda and its CEOs are accused of fraud, money laundering and other disgusting stuff.

The truth is optimism bias makes us prone to investing mistakes because it tends to make us less than appropriately cautious with our investment decisions. The mistakes we make stem from an illusion of knowledge and/or an illusion of being in control.

The fear of being wrong is actually more helpful in investing- this does not mean having a pessimistic outlook.

Ray Dalio, for example, the founder of the world’s largest hedge fund, Bridgewater & Associates, has often commented that being overconfident can lead to disastrous results. In an interview with Forbes, he attributed a significant amount of his success to avoiding any optimism bias.

Dalio’s statement regarding his analytical ability is a powerful one coming from someone who, by all accounts, might be well-justified in thinking of himself as above average at investing.

Zoom -In

Optimism bias refers to our tendency to overestimate our likelihood of experiencing positive events and underestimate our likelihood of experiencing adverse events.

As investors, we need to reign in our optimism bias and instead develop a mindset always to strive to consider worst-case scenarios, so we can take appropriate steps to minimize our risk of loss.

Investors need to make it a point of being keenly aware of the possibility of our or our fund manager‘s assessments being incorrect.

For investors, optimism bias is as toxic as pessimism!