Wikipedia of Finance - e-learning course on Financial Planning Wikipedia Chapter - What is Optimism Bias –Definition, Effects on Financial Decisions

What is Optimism Bias – Definition, Effects on Financial Decisions


Optimism Bias Definition:

Optimism bias is a cognitive bias that makes an individual believe that they will be relatively safer than others if any negative event were to occur. When someone’s subjective confidence in their judgments is reliably greater than their objective accuracy, that person has optimism bias. It is like living in the utopia itself, where every woman is bold and strong, every man is a handsome man, and the children are excellent all rounder. We are only correct about 80 per cent of the time when we are 99 per cent sure. Almost 94 per cent of college professors believe they have above-average teaching skills, I seriously doubt that and anyone who has gone to college will too.

Factors causing optimism bias to a person are – the desired end state, the cognitive mechanisms, the information they have about themselves versus others, and overall mood. The optimistic bias can be noticed in number of situations. Optimism bias examples includes people believing that they are less at risk of being a crime victim, first-time bungee jumpers believing that they are less at risk of an injury than other jumpers, smokers believing that they are less likely to contract lung cancer or disease than other smokers, or traders who think they are less exposed to losses in the markets. Many investors fall into the trap of believing they can pick winning investments every time. As a result, they sometimes put too much of their wealth into one single investment, such as a company stock, or a mutual fund which is highly risky. Research shows that picking winning investments is incredibly hard to do, even for professional investors.

Effects of Optimism Bias on the Financial Decisions:

Optimism biasness is a kind of over confidence that an individual has owing to which he often ends up making bad decisions. About every overconfident investor is only a trade away from a very humbling wake-up call.

Humans are prone to optimism bias and problems related to it when it comes to finance. Psychological studies show that, although people differ in their degrees of overconfidence, almost everyone displays it to some degree. There is also a tendency for individuals to place too much confidence in their own investment decisions, beliefs and opinions ignoring the real and alternative possibilities of their decisions.

Picture confidence as a continuum – Lack of confidence is paralyzing, self-confidence is good for you, but overconfidence can be deadly. Overconfidence often causes great deal of trouble for investors who mistake luck for skill. For instance when something turns out well after a decision you’ve made, you want the credit desperately. However, when something goes south, we ignore the situation by claiming it to be bad luck or misfortune.

Investors who are over confident have a tendency to buy and sell assets too often, which ultimately shows negative effect on their returns. Many studies have proven that long term trade with less frequent and selling is more beneficial than those which involve recurrent buying and selling.

Documentation and reviewing your investment record can give you a reality check and can help you in lowering your over confidence. Your one achievement can be inside your head like a victory medal, but the rest of the failures and under average performance will keep your feet down on the ground. Optimism bias example – it’s easy to remember your one stock that earned you over 50 per cent of the investment in a single day, but most of your investments are under water for the year. Successful investors seek to find a balance between rashness and timidity.

A common mistake done by most of the individuals as an investor is assuming that there is gaining above average returns. Also they tend to develop a vague notion about fund managers who have access to the best investment industry reports and computational models in the business, can still struggle at achieving market-beating returns. Before they really understand something about investing in the market, they either lack confidence or express overconfidence; both of them prove to be fatal. A common type of overconfidence brooms from inexperience. An ideal and intelligent fund manager knows that each investment day presents a new set of challenges and that investment techniques constantly need refining.

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