This article was first published by Truewealth Publishing.
Not believing in yourself can make getting out of bed – to say nothing of facing the world – a struggle. But having too much confidence could be even worse – for your portfolio, at least.
As humans, we tend to be overconfident. We like to see ourselves as above average, and better than our peers. We generally believe that the future will be better than the present – whether that means getting that work promotion, winning the lottery, raising our kids to be Mother Teresa or Albert Einstein, or earning a massive return on that sleeper stock. In general, we rate our chances of success tomorrow more highly than history suggests we should.
Optimism bias is the tendency to overestimate the likelihood of good things happening to us in the future. Being optimistic is hardwired into our thought processes.
For the human race as a whole, this is a good thing. People with mild depression have been shown to perceive the world in a more realistic manner than the rest of us. As such, they don’t possess the optimism bias that a more mentally healthy person does.
And in some cases, the bias swings too far in the other direction. Those with severe depression tend to have a pessimism bias, and expect the future to be much worse than it’s likely to be.
How overconfidence often creates optimism bias
One survey of a million senior high school students in the U.S. found that approximately 70 percent of the students believed they had “above-average” leadership skills, while only 2 percent considered themselves “below average.” What’s more, about 60 percent thought they were in the top 10 percent in terms of their ability to get on with others. And a massive 25 percent thought they were in the top 1 percent.
(The American humourist Garrison Keillor famously described the fictional site of some of his stories, Lake Wobegon, as a place “where all the women are strong, all the men are good-looking, and all the children are above average.”)
Optimism bias also explains why we generally discount the chances of experiencing major setbacks in our lives. Do we realise that, statistically, we’re more likely to grow a third head than we are to win the lottery? Or that there’s a very good chance that our kids will turn out normal, and that great stock will crash? According to the research, it’s pretty clear: We don’t.
A 1987 study by psychology professor Neil Weinstein involved surveying people who engaged in high-risk lifestyles. Asked to rate their chances of getting cancer or becoming an alcoholic, most respondents said their chances – which were undoubtedly high – were between “average” and “lower than average.”
Thus, we tend to think that we face less risk than others. And this is often because we base our predictions – incorrectly – on past experience, adopting the “so far so good” mantra.
How optimism bias can hurt your portfolio
Optimism bias leads to high expectations of the future – including of future investment performance. If we’re too positive about how much a stock will go up, we’re going to be disappointed. And again, being overconfident – and to a lesser extent, simply hopeful – tends to be the cause of our downfall.
Venture capitalists (VCs) are widely thought to be particularly skilled at identifying and funding new ventures, such as technology company start-ups. But a 2001 study found that 96 percent of participating VCs exhibited “significant” overconfidence – which affected their decisions.
This bias is reflected in investors’ viewpoints on Japan in the early 1990s. Japan had posted spectacular economic growth over the previous decades and many optimistically thought this would continue. But it ended up being the beginning of a “lost decade” – which has been ongoing for now over two decades. (This is also connected to “status quo” bias, which we wrote about here.)
Optimism bias has a number of causes. We often want to uphold a certain image of ourselves. A financial advisor, for instance, will want to convey confidence and positivity to his/her clients when recommending investment decisions. But often this image inflates the advisor’s ability to generate big returns.
Although overconfidence may not always lead to the wrong decision, it can prevent us from learning more and getting the complete picture. So you might not have all the information needed to make the best decision. Or you may rely on – and recall – past investment successes, while ignoring the failures. And you end up making the same mistakes again.
But overconfidence and hope can also be powerful tools. For one, they can motivate us to invest in the first place. Without believing that they’re going to make money, few people would invest (or for that matter, even get out of bed in the morning).
As Dan Ariely, a behavioural economics researcher, said, “A society in which no one is overly optimistic and no one takes too much risk wouldn’t advance much.” Underestimating such risk, though, is ultimately what gives investors the biggest headaches.
Dealing with optimism bias
The first step to defeating optimism bias is to be aware of its existence and its effects. Noticing that you are being overconfident, or simply hopeful, will act as a brake and help you clarify the basis of your decisions. And then you’ll be able to invest like a psychopath more easily.
And remember that past performance is no guide to the future. Just because a fund made 60 percent last year does not mean you should just be hopeful that it will continue to head skywards for the remainder of the year. And it doesn’t mean that you should ignore other potential opportunities.
Like the overly optimistic investors who thought Japan’s success would continue… and missed out on the future rise of China. (Which began taking shape as Japan’s economy started to slow down.)
On the other hand, if you’ve thoroughly researched an investment opportunity and you have good reason to be optimistic, fear of optimism bias shouldn’t hold you back. A positive outlook based on reality, rather than a hunch or a feeling or selective memory of past success, is much more solid.
By coldly assessing both the potential returns of an investment and your own capabilities as an investor, you’ll be able to see much of the investing world exactly as it is.
This article was first published by Kim Iskyan at Truewealth Publishing, an independent investment research firm focused on taking the mystery out of finance and investing. We want to empower investors to make better and more profitable investment decisions on their own.
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