Optimism is good, but not when it leads to systematic (predictable and continual) errors in our decision making. Psychologists refer to this error as optimism bias. In this article, we discuss how optimism bias is likely to affect your personal finance decisions.

The bias

If insurance is about indemnifying losses, then an individual ought to buy a term insurance policy- one that has no benefits if an individual survives the coverage period of the life insurance policy (say, till age 85). This typically leads many individuals to overestimate their chance of surviving their 85th birthday. The upshot? They buy insurance policies with survival benefits, which have substantially higher premiums. It is moot if such insurance policies are optimal; you could consider buying a term insurance policy and investing the differential premium in equity funds.

Most individuals are comfortable investing in real estate than in equity. This comes from the optimism that real estate investments will always generate positive returns. In this case, the optimism bias comes from a simple observation- that real estate prices have not crashed the way equity prices have in the past. But just because an event has not happened in the past does not mean it cannot happen in the future (referred to as the conservativism bias).

Finally, consider active funds. Technically, it is simpler to choose passive funds such as exchange-traded funds (ETFs) and index funds. Yet, the lure of generating returns greater than a benchmark index (positive alpha) prompts many individuals to invest in active funds. This despite research that has shown that a significant number of active funds underperform their respective benchmark indices. The decision to choose an active fund, perhaps, comes from the optimism that the funds an individual chooses will generate positive alpha.

Conclusion

Optimism is good. Optimism bias is not, as it leads to systematic errors in our investment decisions. Perhaps, when the outcome of your investment decision is uncertain, it is better to consider the worst-case scenario. What if the active fund you invest in underperforms? Would you still be able to achieve your life goals? Or what if the land that you bought does not appreciate in price? Are you willing to hold for a longer period or use it to build a house? Considering the worst-case scenario relating to your investment decisions helps you be mindful of the risk of financial ruin- how will a significant decline in investment value affect your lifestyle and goals.

(The author offers training programs for individuals to manage their personal investments)

Published on October 14, 2024