Is optimism bias ruining your investments?

Optimism bias is the human tendency to believe that things will turn out better than they will.

Experts believe it is not a lack of insight or intelligence that makes us abandon caution, but a behavioural tick hardwired into our brains known as optimism bias. It can be dangerous and lead to crippling financial decisions.

By Candice Chung

Anyone who has ever signed a gym contract, attempted an alcohol-free month or jumped headlong into an elaborate new hobby has felt the rush of adrenalin the moment they take the plunge. At the precipice of each decision, we have a tendency to picture the outcome with unwavering optimism, despite what previous mistakes should have taught us.

This is what makes us underestimate the likelihood of experiencing negative events such as falling ill, divorce, or misjudging the risk of losing money on an investment. 

“Optimism bias is the human tendency to believe that things will turn out better than they will,” says Andrew Macken, chief investment officer at Montgomery Investment Management. “It’s entirely common – even among those who are aware of it.” 

Recent research by Dr Tali Sharot, a neurosecientist at University College London, found that up to 80 per cent of people are afflicted with the bias. What makes it uniquely dangerous - especially when it comes to key financial decisions - is that we often look through rose-tinted glasses. 

“Overestimating the upside of financial or business decisions can encourage us to leap to decisions that may not be thought through.” Clare Goodman, The Why

“We’re optimistic about ourselves, we’re optimistic about our kids, we’re optimistic about our families, but we’re not so optimistic about the guy sitting next to us,” Sharot says in a TED Talk

While we’re quite capable of appraising other people’s situations with objectivity, or even cynicism, Sharot found that optimism about our personal prospects tend to remain curiously persistent. 

“It doesn’t mean that we think things will magically turn out okay, but rather that we have the unique ability to make it so.” 

The downside of optimism

As humans, we are poor predictors of our future. While our ability to imagine a brighter version of today is what drives us to seek change, the same habit also exposes us to unexamined risks, sometimes with disastrous results. 

“On a day-to-day basis, optimism bias affects our risk profile,” says Clare Goodman, neuro leadership specialist and director of insights at consulting firm The Why

“Overestimating the upside of financial or business decisions can encourage us to leap to decisions that may not be thought through,” she says. 

“Underestimating the negative possibilities can lead to a Pollyanna approach to financial decision-making, or the tendency to remember pleasant events more accurately than unpleasant ones, leading to reckless behaviour. Critical thinking and the ability to see possible issues is valuable. It enables a manager to adapt and adjust strategies throughout [a] project.” 

Essentially, a blindly optimistic view can be as problematic as a consistently underinformed one. 

Goodman cites the 2008 global financial crisis (GFC) as a classic example of how optimism about the inevitability of financial growth on a mass scale can lead to disaster. 

The same applies to companies where executives are disproportionately optimistic about their company’s future, compared to the views held by employees. 

“This gap between a leader’s expectations and vision and the workers’ experience causes significant problems,” Goodman says. “Organisational cynicism can grow, which often impacts discretionary effort, motivation and willingness to change.” 

Professional Development: Thinking like a CFO – making financial decisions. Learn how a CFO perspective is applied to many of the activities and financial decisions you make on a daily basis.

Accounting for optimism bias from the start

Even the best of us can be swayed by a subconscious pull towards optimism. The key, it seems, isn't to eliminate bias entirely, but to account for from the outset - be it on a private investment or project level. 

I have seen first-hand the optimism that creeps into financial forecasts that underpin large-scale, multibillion-dollar capital investments," Macken says. 

"Investments that sometimes should be made are made. Timelines and budgets are systematically underestimated and even mergers or acquisitions that should never be made are pursued as a result of overly optimistic expectations."

Macken advocates taking a “premortem” approach to making important financial decisions. 

“Before you make an investment or some other financial move, pause and ask yourself the question: ‘Let’s assume we are a few years into the future and this has turned out to be a terrible financial decision – why was this so?'"

In other words, picture an investment collapsing. Then imagine playing a game of reverse Jenga with it – what were the key moves that would have caused the whole things to come apart? 

“You are then forced to honestly think through realistic scenarios that could lead to really negative outcomes,” Macken says. 

“Just by thinking through some of these negative possibilities ahead of time – not just the positive ones we would naturally imagine – we have a better chance of basing decisions on reality, rather than optimism.”

Of course, everyone still needs a degree of optimism in order to take risks and embark on new projects. 

“The crunch comes when a positive view of the future collides with the problems we’ve learnt from experience,” says Goodman. 

“To ground an optimistic outlook, it is essential to use inevitable setbacks and challenges as a feedback loop to reassess a situation.”

How to avoid optimism bias

To avoid the trap of optimism bias, here are some questions we can all ask ourselves to sense-check decisions, according to The Why’s Clare Goodman: 

  1. What are you trying to achieve with a particular financial decision?
  2. What can you afford to lose?
  3. What key things need to happen for it to succeed, and what will be the consequences if they do not occur?
  4. What would be an early warning signal that a decision is on or off track? 
  5. What are your plans B and C?

Read next: 5 simple rules for making better decisions

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