Investing – Can Optimism Work Against You?

Are you a perennially optimistic person? It may surprise you to know that your natural tendency to see the bright side of everything may in fact be hurting your portfolio returns! 

Studies indicate that nearly 80 per cent F5 of us suffer from what is called the “optimism bias” – so we go around believing that “bad things happen to other people”.  The vast majority of investors overrate their abilities, moving from the “zone of rationality” to the “zone of over-confidence” as a result. 

Heather Lench of Texas A & M University proved this bias in a study titled “Automatic Optimism”, during which she discovered that people are, in general, one and a half times more confident that they would encounter positive life events than negative ones. Here’s the more interesting observation: when put under time pressure, people became twice as confident of encountering positive life events than negative ones! Optimism seems to be our instinctive response; and the pressure to take time-bound investment decisions only serves to amplify this tendency. And why not? Optimism is hardwired into our brains as a survival tool! 

Unfortunately, the optimism bias is dangerous for investors is because it promotes poor decision making and misjudgement. Blindsided against potentially severe market risks even when negative indicators are staring them in the face, overoptimistic investors are the first to burn their fingers severely during the early stages of a bear market. This is why retail investors repeatedly invest near the peaks of bull markets. In this regard, history repeats itself with startling regularity! 

The optimism bias is rooted in the illusion of control; the mistaken belief that we can influence random outcomes that we actually cannot. Further, there are five conditions that amplify this illusion of control: a high availability of information (business news channels), early success at a task (beginners luck), a personal stake in the matter (money), familiarity (your trading terminal), and the availability of many choices (more than 5,000 listed stocks and 2,500 mutual funds from 40+ AMC’s to choose from). When you think about it, all these factors practically define the environment of stock market investing! It’s no wonder then, that irrational optimism kicks in at a moment’s notice. As a result, investors regularly mistake “randomness” for “control”; often leading to huge judgment failures. 

Benjamin Graham, widely accepted as the father of value investing, observed that “chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions”. In other words, irrational exuberance about current occurrences clouds their ability to make sound decisions about the future. 

The optimism bias is admittedly hard to overcome, but you could start by taking lessons from professional investors; if anything, they tend to be more “cynical” when selecting investments than retail investors!  

Learn to make “no” your default response to new investments, and aim to collect facts that prove otherwise. If you play it the other way around, you run the risk of trying to mould reality to fit your own (optimistic!) viewpoint. By becoming a critic, you’ll be concentrating your investments into high-conviction bets instead of spreading yourself too thin. You’ll also be greatly reducing the odds of catching a bull market by its tail!     

So, the next time you find yourself ready to make a brave investment against common sense and sound logic, and that reassuringly optimistic voice in your head whispers “this time it’s different”; silence it and walk away. It almost never is.