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Thursday 9 August 2012

Unrealistic Optimism and the Impoverished Investor

Hope is the thing with feathers that perches in my soul - Emily Dickinson
Eternal Optimists

Humanity is unrelentingly optimistic in the face of contradictory evidence.  Our ability to demonstrate unrealistic optimism bridges cultures, races, genders and societies.  We simply will not face up to the nasty reality of the real world, whatever that is.

This bias is so pervasive that it’s highly unlikely to be a social adaptation to culture and is probably an evolutionary trait, hard-wired into our brains.  No matter how it arises, it’s going to induce investors to take a positive view of the world: a view which cuts right across behavioral investing rule number one.

The Smoking Gun

The evidence showing we're unrealistically optimistic spans all sorts of areas.  Divorce lawyers, for instance, are far too blasé about the negative impacts of ending relationships and people generally disregard the evidence suggesting that they’re at risk of various medical complications caused by lifestyle choices. Cough, splutter.

The evidence from investment analysts that they're unrealistically optimistic about future corporate earnings has a long history going back to Werner de Bondt and Richard Thaler’s paper Do Security Analysts Overreact?  They pointed out that such unrealistic optimism may actually be a so-called agency issue: analysts and their employers are rewarded for issuing optimistic forecasts.  However, the increasingly general finding is that people are actually unrealistically optimistic about the future regardless of incentives. This seems to be a powerful human trait, so the suspicion is that analysts would be optimistic anyway, even if they weren't paid to be so. 

It'll Be All Right, Probably

Worryingly this is all bound up with our general inability to correctly calculate the impact of current choices on future states. This issue, which is roughly covered by the term “hyperbolic discounting”, means that we value current consumption more than future consumption.  In the simplest economic terms we prefer to buy something now for immediate gratification rather than save now for the future – and because we’re innately, if wrongly, optimistic about the future this makes some sort of sense (see: Putting Down The Credit Cards).

There are all sorts of behavioral problems implicated in this.  Procrastination, for instance, is the inability to make difficult decisions about the future when presented with too many choices.  Yet, viewed through the long lens of history the failure to make any choice at all is a terrible decision; somehow we manage to ignore the future consequences of our current decisions, somehow it’ll be all right, eventually (see: Retirees: Procrastinate at Your Peril).

In particular we’ve seen that those people who don’t relate to their future selves are far less likely to save for their futures.  Here individuals are managing to disassociate themselves from their futures, and the consequence of this is to avoid worrying about taking long-term precautions – an issue that spreads beyond financial matters and into matters of health and relationships and condom sales (see: Be Kind To An Old Person: Start With Yourself).

We know also that some of this behavior can be predicted through tests of childrens’ self-control at ages as young as three.  Those able to demonstrate control will have far better life chances, will make better decisions and, so far, have exhibited far better planning skills for their future selves.  Although, of course, if you’re more successful you have more resources with which to prepare for future events (see: The Secret of a Healthy, Wealthy Life).

The Failure of Feedback

All of these behaviors are linked to over-optimism, an overly rosy-eyed view of the world.  What’s really peculiar about this is that we get plenty of feedback that our upbeat expectations are wrong; they’re continually being dashed by hefty does of reality.  Yet most us remain relentlessly, and wrongly, optimistic about the future.  And we now have evidence that this isn’t simply a cultural bias towards positivity, but is actually hard-wired into the brain.

Thanks for this go to Tali Sharot, Christoph Korn and Raymond Dolan who, in How Unrealistic Optimism Is Maintained In The Face Of Reality, have been able to show that this behavior is linked to asymmetries in so-called belief updating. To put this in English, we tend to ignore information that ought to reduce optimism and to take notice of information that reinforces it:
“Participants updated their beliefs more in response to information that was better than expected than to information that was worse.”
In fact the behavior demonstrated is peculiar in the extreme.  Basically if you provide people information that allows them to become more optimistic then they’ll learn more effectively than from information that should make them less optimistic. This, of course, sounds an awful lot like confirmation bias – we will happily accept information that confirms our prior opinions, but we find it much harder to take on that which disconfirms it (see: Confirmation Bias, The Investor's Curse).

Death Becomes Us

The research specifically implicates a particular area of the frontal cortex, where information about the future is encoded.  People who pre-scored highly for optimism traits were particularly bad at tracking negative errors in this area, where their optimistic view of the world should have been undermined by the evidence they were presented, but wasn’t.  In effect, positive information was weighted more highly than negative.

Presumably this weighting provides some evolutionary advantage.  The researchers note:
“Underestimating susceptibility to negative events can serve an adaptive function by enhancing explorative behavior and reducing stress and anxiety associated with negative expectations. This is consistent with the observation that mild depression is related to unbiased estimation of future outcomes and severe depression to pessimistic expectations.”
Of course, our ability to look ahead means that we have foreknowledge of the most depressing thing of all: our own deaths.  Being relentless over-optimistic may be nature’s way of ensuring we don’t spend all of our lives in bed with a sheet over our head awaiting the inevitable arrival of the Grim Reaper.

You can easily see how this affects investor behavior which is, after all, measurable in terms of actual returns.  If your feedback from your investment in llama farming is positive – you’ve found a glorious winner – then your frontal cortex will happily update itself with the good news: you’re a great investor and llamas are hot. On the other hand, if it all goes terribly wrong and the bottom falls out of the llama market then you’ll note the fact that llamas aren’t quite such a good investment as you thought, but you’ll likely put this down to bad luck with the llama harvest and move on to the next great thing without spending much time thinking about it.

Why Not Sell?

Of course, great investors do no such thing.  Forcing ourselves to confront our own investing mistakes, and encoding that learning in a way that’s difficult to ignore – probably by adding yet more filters to our investing checklist – will make us better investors.  And it’ll lead to less of those depressing days when the llama futures market tanks and we're left with a warehouse full of llama wool ponchos no one wants.

Nature isn’t destiny, but investors shouldn’t ignore the impact of over-optimism on their investments; particularly after they’ve invested, when the effects of confirmation bias kicks in.  As the research shows this is not just a mental weakness, but a neural mechanism and overcoming it will require hard work. Rule number one is always look for reasons to sell; you brain will generate plenty of reasons not to, all by itself.

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