#2 - Optimism Bias: Exploring and Refuting Common Investor Behavioral Biases

R.P. Seawright of Above the Market recently released his list of “Investors’ 10 Most Common Behavioral Biases,” a valuable juxtaposition of most common investing mistakes with the behaviors and attitudes behind those same mistakes. This article is a series of expansions and explorations of each bias.

Investor Behavioral Bias #2: Optimism Bias

How confident are you in being right? If you’re like most individuals, you’re correct only 80% of the time when you believe you’re at least “99% sure” of being right. (Source) Neuroscientist Tali Sharot presented an excellent TED Talk on the subject of optimism bias in Long Beach, California in 2012. Sharot demonstrated that divorce rates among the western world aggregate to approximately 40 percent, but newlywed couples when asked are most likely to predict their likelihood of divorce at a much lower rate: zero percent.

Overconfidence in our ability to be right is a classic behavioral bias, especially when it comes to financial investing. Our subjectivity, and sometimes blind optimism, can wrongly convince us that our ability and decision are better than they truly are. Many of us believe we are better drivers, parents, employees, friends, and even overall people than we actually are. A 2007 survey of British citizens revealed that 97 percent of respondents expressed optimism about their family’s future compared to 17 percent who expressed optimism about the future of other families. (Washington Post)

Optimism bias can lead us to be more hopeful towards investment futures than we should. While optimism bias can be dangerous, a cornerstone principle of financial investments is hope. Mergers and Acquisition (M&A) agreements are based in hope for future growth and return. We have hope that a portfolio investment will mature in value, which is why we invest in its future with a stock purchase today. We believe in long-term financial dividends based on positive outlooks through careful, unbiased research and investing decisions. Without hope and belief in potential positive outcomes, there would be no future for financial investments.

As with any investor behavioral bias, awareness of the existing bias and its effect can better position investors for dispassionate financial decisions. Consider and weigh the consequences of both success and failure in all investing decisions and rely on a trusted financial advisor to contribute expert insight for a well-balanced portfolio.