The Optimism Bias

I am currently reading a book titled “The Optimism Bias: A Tour of the Irrationally Positive Brain” by Tali Sharot (see below for Amazon link). The Optimism Bias is simply: “our tendency as humans to overestimate the probability of positive events and underestimate the probability of negative events”. The author believes that the human brain developed this tendency to help us survive as a species. Our caveman ancestors may have been starving “today”, but surely there would be food “tomorrow”. It’s that hope for a better tomorrow that kept our ancestors from giving up and starving to death. Today it’s what keeps us going after a negative life event like being fired from our job, a nasty divorce or the death of a loved one.

What better year to examine The Optimism Bias under an investing lens than 2020?! Were market participants exhibiting the Optimism Bias at the March 2020 lows in the S&P 500 with the index down about 34%* from its February high? Clearly not. The news was bad and getting worse. Investors were selling assets indiscriminately. Global markets were tanking every day. Pessimism reigned. Where was the Optimism Bias then?

The Optimism Bias is at odds with another psychological phenomenon called “loss aversion”. Loss aversion says that humans have a tendency to prefer to avoid losses when compared to acquiring equivalent gains. In simple English: it “hurts” more to lose $100 than to gain $100 and therefore we work hard avoid that feeling. Loss aversion was pioneered by Amos Taversy and Daniel Kahneman who were the subjects of the Michael Lewis book, “The Undoing Project” (also a great read, see below). So when looking at these two phenomenon together, we can say that loss aversion definitely won out over optimism bias in early March.

If you were able to overcome your loss aversion at that time and hone in on your optimism bias then massive gains were in store for you. When I look back on my blog posts from that time, Recent Note to Clients and What Now?, I can see the optimism bias inherent in the writing. The summary of both posts is that “things are bad – they could get worse – but that does not mean stocks have to go down any further – in fact, there could be gains ahead – but for reasons unclear to me yet”. This is the optimism bias in action – it’s what kept me and my clients invested through the “Covid crash” and through the 2020 presidential election.

What’s the point? Are you saying I should always be an optimistic investor? I do think being an optimistic investor is better than being a pessimistic investor over the long run. But here is my main point: you don’t need to be optimistic all the time, but when all other investors are panicking and selling – that’s when you really need the optimism bias. It’s what kept our ancestors searching for their next meal when they were starving. It’s what keeps prisoners of war from giving up after being captured. Heck, it’s what got all of us through the year of 2020 in general. Having a bias towards optimism is what will get your portfolio through our next crisis. Something to focus on for 2021.

The Optimism Bias: A Tour of the Irrationally Positive Brain: Sharot, Tali:  9780307378484: Books
click for Amazon link

The Undoing Project: A Friendship That Changed Our Minds: Lewis, Michael:  9780393254594: Books
click for Amazon link

* 2/19/2020 to 3/23/2020 – from Koyfin Charts.

**The above article is informational in nature only and is not a recommendation to buy or sell securities.  All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information.  All investments carry a degree of risk.  Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.

***Securities and Investment Advisory services offered through Ausdal Financial Partners, Inc, 5187 Utica Ridge Road, Davenport, IA 52807 (563)326-2064. Member: FINRA/SIPC. M.Brown and Associates / M. Brown Financial Advisors and Ausdal Financial Partners are independently owned and operated.