Optimism Bias Definition
Optimism bias refers to an unrealistically positive outlook where an individual assumes that though negative events occur, they can never happen to them. At the same time, these individuals believe they are more likely to experience positive outcomes than people around them.
Some investors suffer from an illusion of invincibility. They presume that the market misfortune will only affect others. As a result, they fail to analyze the negative consequences. One might get away with some level of over-confidence in day-to-day life, but not in financial decision-making.
Table of contents
- Optimism bias is an illusion. Overtly optimistic individuals believe that nothing bad will ever occur to them. They blindly expect positive outcomes at all times. The bias prevents individuals from realizing negative aspects and reality.
- This mindset can severely impair decision-making. Moreover, these individuals fail to take precautions for worst-case scenarios.
- The bias is caused by overconfidence, high self-esteem, careless attitude, and an illusion that situations can always be controlled.
- Impaired cognition can be overcome with rational thinking, availability heuristic, loss aversion, and reference class forecasting.
Optimism Bias Explained
Optimism bias stems from an unrealistic perception that things will never go wrong. Individuals who have such a biased cognition exaggerate positive events occurring in their lives. To make matters worse, they ignore all the negative aspects. An overly positive attitude is a learned behavior.
Other causes include overconfidence, low-stress levels, higher self-esteem, and a perception that everything can be controlled. Also, the absence of negative experiences in the past promotes this bias—such individuals start believing that only good things will happen to them while adversities occur in others’ lives.
Cognitive biases can cause serious consequences—a biased individual is irrational. Individuals who fail to analyze the negative consequences of a decision end up making indigent choices.
In financial decision-making, an illusion of invincibility can result in huge losses. Many believe that being overly optimistic can provide various health benefits. They claim that positivity keeps them happy. One might even get away with some level of over-confidence in day-to-day life, but not in investing. Financial schemes and frauds target people with such a bias.
Let us understand the practical implication of optimism bias by looking at some examples:
Optimism bias makes people careless—they stop taking precautions. For instance, during the Covid pandemic, many people believed that they wouldn’t get infected and stopped following instructions. This bravado was not backed by any facts whatsoever, most ended up in a hospital.
In October 2021, the US government considered the pandemic a short-lived one. The government was under the illusion that the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society. would soon bounce back. Later, the country faced back-to-back COVID-19 waves, for which it was totally unprepared.
Now, let us understand the effect of optimism bias in investments:
Let us assume that Hugh is an investor looking for the right IPO. He comes across XYZ Limited; the company was popular, but its finances were down. It was releasing an IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. to raise funds and clear debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state..
Hugh, however, invested without attempting any analysis. Hugh had an optimistic bias—he blindly believed that his investment would yield record-high returns. He overlooked the fact that stock prices can even go down. Eventually, stock prices fell by almost 30% in the initial trading week—Hugh incurred a huge loss.
How to Avoid it?
Optimism bias keeps people from reality. When a negative event occurs, biased individuals are ill-prepared. The following steps can help avoid optimism bias:
- Think Rationally: Being practical is not an option; it is a necessity. One must understand that every event has a probability of ending negatively or positively.
- Loss Aversion: Accepting failures, just like one accepts success, can help mitigate biases. Instead of focussing on profits all the time, one can make decisions to avoid losses.
- Learn from Others’ Failures: It is necessary to consider the negative experiences of others before deciding.
- Compounding: One must analyze the risk associated with every investment. Look out for products that offer consistent returns over the period—avoid products that claim high gains in a short period.
- Availability Heuristic: Don’t forget unpleasant experiences. Heuristics is the ability to recall negative occurrences from the past to make sensible choices in the future. Simply put, don’t make the same mistake twice.
- Reference Class Forecasting: Investors should judge new investment products by comparing them with past profits, yielded by investment products belonging to the same asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples..
Frequently Asked Questions (FAQs)
Optimism bias causes people to assume that they will never face negative circumstances. They notice bad things happening to others but still assume nothing of that sort can ever happen to them. They blindly expect positive outcomes.
Optimism bias is caused by the following reasons:
– Motivational content triggers the human brain and causes euphoria. The audience starts believing that nothing wrong can happen. Motivational books and videos are the primary causes behind optimism bias.
– A lack of negative events in one’s past also leads to believing things will always stay positive.
– People fail to analyze others’ failures and the extensive data available around them. They are unable to learn without experiencing something first-hand.
– Other factors include overconfidence, low-stress levels, high self-esteem, and a perception that everything can be controlled.
The following measures can counter optimism bias:
– Be rational and look at both sides of a coin—consider both the negative and positive aspects of a scenario.
– Be objective—examine all events, opportunities, and threats from an unbiased third-party outlook.
– Face negative consequences and don’t run from them,
– Always consider the worst possible scenario before deciding.
– Consider risk factors associated with each decision and scenario.
– Learn from others’ mistakes.
This has been a guide to what is Optimism Bias & its definition. We discuss optimism bias meaning, unrealistic optimism, examples, & how to avoid it. You can learn more about it from the following articles –