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What is 'optimism' bias? [video]

We often assume things will turn out better than they do

    Optimism bias is one of the most prevalent behavioural biases investors are prone to

    It's something you need to guard yourself against so it doesn't impact your investment returns 

    Professor Bent Flyvbjerg from Oxford University explains why it's so difficult to combat optimism bias

    RP: Of all the behavioural biases people are prone to, one of the most prevalent is optimism bias. We typically assume that things are going to turn out better than they do, and we overestimate the control that we have over events.

    BF: It is widespread and it one of the things that really need to guard yourself against as an investor. Both your own optimism but also other people being optimistic about your money, it is also a thing that can really trip you up and lose you a lot of money.

    Even people go into casinos where it is not very much dependant on your own skills have this optimism that they’re going to beat the odds of the casino, that’s why you go playing right? Of course, it comes out not to be true same in the financial markets. So that's just something we have. The hardest thing to learn is not to be optimistic, it is really difficult. It takes actually a lot of time and a lot of experience, and they have very few investors out there who have this cool realism that will make you successful as an investor.

    RP: Overcoming optimism bias isn’t easy. But, says Bent Flyvbjerg, there are two important things we can do to minimise its negative impact.

    BF: The first thing is to realise that you do have optimism bias. We are all biased. The first thing is to realise is “I’m biased” and then take it from there and of course, if you are biased you need to be “de-biased” so you need to de-bias your decisions and that’s actually possible.

    Just telling people about what the empirical dates are regarding the decisions that they are making will make them less bias. It will not eliminate the bias, it’s doesn’t go to zero but it will eliminate thirty to fifty of the bias.

    RP: But says Professor Flyvbjerg, there is a more effective way to tackle optimism bias, and that is to minimise the number of subjective decisions that we as investors make to an absolute minimum.

    BF: The real secret to getting bias out is not to make subjective decisions you basically want to make decisions that are more or less automatic. So instead of trying to time the market, if you were investing and say “I’m going to invest every three months on a specific date, I’m going to invest whatever I have at that moment I’m investing.” and if you do it like that every three months you are investing, you will do better than if you try to save up your funds and figure out where the market is going, and then try to time the market.

    Optimism bias has to have an opportunity to kick in and that is only when you make subjective decisions. That is when it kicks in, so the more you can eliminate those and go on autopilot so to speak, the better off you will be in making investment decisions.

    RP: Professor Flyvbjerg is also, incidentally, a strong advocate of indexing.

    Using passive funds, he says, limits the danger of being tripped up by optimism — either your own or by other people’s.

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