Generally speaking, it’s good to have a positive outlook on life. But too much optimism, or overconfidence, can be a problem, particularly when it comes to investing.

In this video, Lisa Bortolotti, Professor of Philosophy at the University of Birmingham, explains why investors need to be realistic.

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Video transcript:

Generally speaking, it’s a good thing to have a positive outlook on life, and to be reasonably optimistic about the future. It’s better for our health and mental wellbeing for a start. But there are potential pitfalls too. Lisa Bortolotti is Professor of Philosophy at the University of Birmingham and an authority on the dangers of overoptimism and overconfidence.

“I think, where you see the negative effect is where you have context, where things are so complicated that being optimistic about your competence or your performance leads you to making mistakes and taking too many risks. So, finance is an obvious case. Finance is very complicated. You need to take into account the relative value of different options and the idea that you will make the best decision because you’ve made a very good decision in the past where you tend to think your previous luck as skill makes you too confident about the decision you make and less likely to listen, maybe, to other people and take into account different factors.”

A tendency towards optimistic bias or unrealistic optimism is part of the human psyche. It’s the way we’ve evolved. Behavioural experts have identified different dimensions to it. One of these they refer as the Illusion of Control.

As Bortolotti explains, “The Illusion of Control is when something is happening and we witness the thing happening and we tend to think that we are actually interfering with what is happening and determining the outcome. I think, in the financial world it’s possible that we may think that we will be able to know whether a certain company will be successful or whether certain rates will go up or down. And this capacity, that we think we have to predict how things will go, will make us make decisions that are more bold and do not take into account other factors that we should factor in.”

Another aspect of optimism bias is the so-called Illusion of superiority. In other words, thinking we’re better than we actually are.

“The superiority bias, which is also called the 'Better Than Average Effect’, is the idea that we tend to think of ourselves as better than average - in a number of domains. So, we may think that we are more attractive, smarter, more generous as well. Now, The better than average effect has been observed across the board and it normally works in combination with the optimism bias to make us make predictions about the future that are too positive, too rosy, because if I think that I have a lot of skills and a lot capacities and I think that things that are negative will not happen to me, then I will think that I can control what happens in the future, and I can determine a future that is happy for me.”

Again, it’s good to be optimistic and confident to a point. In fact, you need to have a positive view of the future to invest in human enterprise in the first place. But be realistic, and don’t overestimate your ability to outperform other investors.

Picture: Benjamin Davies via Unsplash

We all know we shouldn’t throw good money after bad, but we do it all the time.

Perhaps you’ve made yourself sit through a bad movie purely because you felt that having paid for the ticket you didn’t want to be left with a sense of money down the drain? Or, for the same reason, you’ve read a whole book despite deciding by the end of Chapter 1 that you weren’t going to enjoy it.

The sunk cost fallacy

Behavioural economists call this tendency among people to stick with losing propositions as the sunk cost fallacy. You see it all the time in consumer finance, investment and business.

Think of the person who buys a motor vehicle that turns out to be a lemon. The buyer constantly is sending the car to the garage to be fixed. Yet every time it comes back from the mechanic something else goes wrong. The consumer would have been writing it off early in the piece.

Investors are affected too

This happens with investments as well. People will get overly attached to losing stocks and refuse to sell them, purely because they feel they have already stuck with them for so long and want to believe that at some point they will turn around.

There are a few ways of overcoming this tendency. One is not to become emotionally attached to investments. A bad movie doesn’t stop being a bad movie just because you doggedly opt to sit through the entire feature. Your money is gone; now you’re wasting your time as well.

A second approach is to look to the future, not the past. Maybe the next movie will be better. A third idea is diversification. Accept that not every movie you see is going to hit the mark. But if you see a range of them, something might take your fancy.

See the big picture

A final way of framing this challenge is to think of the big picture. People tend to place a higher value on what they might lose rather than on what they stand to gain. Walking out on a bad movie opens up the possibility of a better experience doing something else.

Bad movie or bad investment, that money and time wasted is gone. You can’t do anything about it. But you still have options and choices. And that starts with writing off a losing proposition.

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