What is 'optimism' bias?

What is 'optimism' bias?

Optimism bias is one of the most prevalent and costly behavioural biases investors face. We tend to assume things will turn out better than they actually do, and we consistently overestimate how much control we have over events. When it comes to your money, that instinctive optimism, both your own and other people's, can trip you up and cost you dearly.

In this video, Professor Bent Flyvbjerg explains what optimism bias is, why it is so widespread, and why it is so difficult to overcome. He draws the parallel with casinos, where players convince themselves they will beat the odds, and shows how the same misplaced confidence plays out in financial markets. The hardest thing for any investor to learn, he argues, is not to be optimistic, and the cool realism that makes investors successful is rare and takes years of experience to develop.

You'll learn two practical strategies for reducing the damage optimism bias can do. The first is simply recognising that you are biased, then actively "de-biasing" your decisions. Flyvbjerg explains that confronting people with the empirical data behind their decisions can cut the bias by 30 to 50 percent. The second, and more effective, approach is to minimise the number of subjective decisions you make. Rather than trying to time the market, investing a set amount on a fixed schedule (for example every three months, whatever the market is doing) puts your investing on autopilot and gives optimism bias far less opportunity to kick in.

The takeaway: optimism bias only strikes when you make subjective decisions, so the more you can automate your investing, the better your outcomes are likely to be. It is no coincidence that Professor Flyvbjerg is also a strong advocate of low-cost index investing, which limits the danger of being tripped up by optimism, whether your own or somebody else's.

Chapters / Key points

• What optimism bias is and why it is so common
• Why we overestimate our control over outcomes
• The casino parallel and how it plays out in markets
• Why "cool realism" is so rare and hard to learn
• Step one: recognising and de-biasing your decisions
• How empirical data can cut bias by 30 to 50 percent
• Step two: minimising subjective decisions and investing on autopilot
• Why automating your investing beats trying to time the market
• Why optimism bias strengthens the case for index investing

Transcript

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

Even people who go into casinos, where it's not very much dependent 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's really difficult. It takes actually a lot of time and a lot of experience, and there are 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, "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 what the empirical data are regarding the decisions that they are making will make them less biased. It will not eliminate the bias, it doesn't go to zero, but it will eliminate thirty to fifty percent 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 said, "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.