The Hindu Business Line : Suffering from optimism bias?

The torrential rains that lashed Chennai last fortnight had its part to play on our house as well. Rain water has never entered the inner gates since the house was built. But it finally happened and we were unprepared. You can attribute our failure to what behavioural psychologists call as the optimism bias. What does that mean?

It simply means that bad things happen to others, not to us! It does not mean that we want bad things to happen to others. It is just that if we read that lightning can strike people and cause death, we always think that it will strike others and not us.

It is this optimism bias that made us think that our house was not vulnerable to the rains as other houses were. Optimism bias makes us overconfident.

Underestimating risks

Take the MBA graduates. It is now well-known that the current job market is not good. Yet, most graduates feel that they can get a job but others may find it difficult to get one!

How is this related to economics and markets? Optimism bias can make us underestimate risks associated with investments. A typical example is the employee stock options. Most employees tend to hold on to their employer-company shares till they quit their job. Why? Among the many reasons, they feel that economic misfortunes will hurt their competitors, not their firm. This is, perhaps, why an average 401(k) plan in the US invests a third of its assets in the employer stock. Some even invest as much as 50 per cent!

‘Home bias’

Then there is the “home bias”. This refers to investors’ tendency to overestimate the economic prospects of their home country than foreign investors would.

Optimism bias, thus, leads to skewed asset allocation decisions — overexposing the portfolio to single stock or sector. This bias is closely related to overconfidence bias, which makes us overtrade in the market. In end, it does not matter if it is your investments, your house or your job, suffering from optimism bias could prove costly. Beware!

(The author is an investment strategist.)

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