Behavioral finance FAQ / Glossary (Optimism)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Optimism / optimistic bias, Overoptimism



03/3i,6i,8i - 04/3i - 06/6i -
07/11d,12d - 08/3i - 09/1i,5d
+ see overconfidence, magical
thinking, bubble, social mood,
sentiment, hope, risk, greed,
illusion

Seeing a rosy future world
Or at least a rosy future for us in the world.

OK for the beatitudes, to be positive is healthy,
...but within limits!


Definition 1 (optimism).

Optimism is the belief and feeling that things have a good
               chance
to come out favorably.

The related emotion is hope (see that word),

   Definition 2 (optimism bias / over-optimism)

Optimism is in itself a bias, with its advantages and drawbacks.

But what is called the optimism bias or over-optimism is an

exaggerated trust, even a full certainty, that things
will turn as we hope, without contemplating other possibilities.

This sentiment can play an important - either positive or
counterproductive - part in
financial
decision making.

More detailed description

A bias, yes, but is it constructive or destructive?

Constructive faith?

Harmful illusion?

Optimism, a feeling that things will come
out well,  is a mental
attitude that tends

to make reality look better than it is

to deny risk or lower its perception.

That bias has its dangers, but it
is useful if it helps look for
solutions or precautions, avoid
passivity or despair.

Studies have shown that moderate
optimism (= that does not deny threats
but thinks there must be ways to
overcome or bypass them) is an
incentive:

To take initiatives, find opportunities 
    and  solutions to help make
    things better,

To persist and carry on a project or
   task among obstacles,

Paradoxically, at the difference of
   over-optimism,
to see things clearly,
   to find ways to spot risks,
   to control them and not be

   overwhelmed by them.

Even more important, to fight stress,

or keep the desire to live.
It is also healthy.

Yes, faith and optimism seems not
only good health factors but also
survival factors in extreme cases.

Optimism that become over-
optimism brings
two distorting
factors in decision making:

Cognitive illusions, as
   unrealistic assessments
    and beliefs,

Emotional motivations, i.e
   hope, greed and ...imitation
   of other people's exuberant
   mood.

Over-optimism in decision-
making is damaging if it leads
to
:

Passivity
    and carelessness (thinking

things will get better by
themselves),

Or on the contrary,

    impulsive but wrong
    decisions and actions guided

by pervasive illusions about
the real odds,

By exaggerating a rosy
outcome
probability, it can
entice not to look beyond,
thus  overlook other
scenarios / possibilities.
Also some quacks might
even play on the illusion of
their healing powers.

The emotional aspects of (over-) optimism
     (and its role in finance)

Optimist by feeling good.


Optimism has cognitive origins, described in a section below.

But better start its analysis with the emotional causes, as optimism
is linked to

* the quest for pleasure

* and/or to the aversion to pain.


They are fully understandable and respectable drives ...as long as they
do not freeze observation, thinking, ethics...

Hope and fear (see those words) are obviously forms of feelings /
moods / sentiments.

They are among the main emotional motivators of action (and inaction).

Hope and fear don't always oppose each other, they sometimes coexist.

To take an example in finance, somebody can avoid to sell a
stock

* either because he hopes it will rise further

* or because he is losing money on it and is loss averse.

Let us look more deeply at the optimism / pessimism role
in business and finance :

  ? or   ?

The hope side

The fact that investors (and business creators) invest and take
initiatives
shows that the hope of success is one of their traits.

Whatever their caution about risks, most of them are also, in some
degree:

Either optimistic about outside events: they think that the
   market will behave in their interest.

Or optimistic about their own capabilities

In other word, confident, and in some cases "overconfident"
(see that word), thinking they can beat the market.

Or under influence, when their optimism is based in following
    always what some other people do.

? or    ?

The fear side

On the other hand, although they agree to take risks, investors
and business creators are also generally (and in various cases
wisely) risk averse in some way.

More precisely, investors have a degree of risk aversion.

For example they usually avoid putting the whole farm
   at stake
, which is usually wise except if higher motives are
   at play.

Also, and here it seems less wise as it could bring passivity,
   they might hesitate a lot before changing horses.

They tend to feel that the way they operate is safer and
better.

Not only this is close to the "endowment effect" and
to the "status quo bias", but it is a form of optimism,
as a trust in practices they know, whether or not
adapted to the situation.

But their behavior might differ from their attitude and overcome
their aversion.

Among the emotional factors, another key one is peer contagion, the
imitation of other people's mood.

The cognitive aspects of (over-) optimism)

Optimist by mistake

Cognitive factors (see cognition) can bring an unrealistic appreciation of the
current situation, of its future prospects, or of the possibilities of success
of one's own actions.

Such self-deception could result from:

An attention bias due to autopilot bias, routine, selective
    perception, anchoring or cognitive overload, 

An error of judgment (logical fallacy, framing,
    reductionism, inadequate heuristic...),

A flawed assumption, for example a base-rate neglect (=
    overlooking the known probabilities),

A short memory,


An illusion of knowledge and ability (see those words),

Here, optimism is taken as a pseudo (*) synonym of
overconfidence in one's own ability to predict and/or control
things,

(*) Careful here! optimism and overconfidence (see that
      word) are often confused, but they are different attitudes.

      For example, somebody can be overconfident in its
      ...pessimistic predictions.


Magical thinking (see that phrase) a relatively
    widespread bias by which people think that luck
can be in their
    side under the superstition that some
events or practices are
    correlated to other events.

Some researches have shown that people remember their
successes and gains more vividly than their failures and losses.

This selective memory can build illusory positive thinking that
lead to irresponsible decision making.


And whatever other cognitive bias and naive beliefs...

Consequences for deciders

Controlling our exuberance?

OK, but not towards inertia.

What is positive

Neuroscience has shown that emotions are usually needed to drive
people to act
.

Thus, feelings of optimism and confidence, as "biases for action", are
positive in some degree.

What is dubious or negative

But in some cases those feelings become excessive (over-optimism,
overconfidence).

Here positive emotions endorse cognitive biases, thwart reasoning and
take over common sense.

Such excessive hope leads to disastrous decisions (or disastrous
non-decisions due to neglect / complacency / delaying...)

One has to realize that things are usually harder than expected and that
results tend not to meet fully the deciders' expectations (the famous
"Murphy law" might spoil the party).

So better be prepared!

In other words:

Deciders should be conscious, and often wary, of "exuberant"

feelings, whatever they express.

  On the other hand they should not repress optimist thinking and

  feelings to the extent of being always overcautious.

If so they would never take any initiative (except for protection)
nor try anything. They would fall into some vegetative state.

Collective optimism and its effects on 
    business and finance in general

When the sound of money invades market street,
shoppers get optimistic.

Collective optimism might help markets run, while over-
optimism could bring serious market anomalies. See (market)
sentiment, mood.


      In assets markets, collective over-optimism, as contagion

  between investors (see mimicry), can bring excesses that
    will strike back
.

What might be active here is

* the intoxicating GG & H cocktail - greed, gullibility and herding - that can
   bring price bubbles.

* that financial analysts have some objective, although dubious

   interest to give optimistjc recommendations, to boost their employers

   activity and / or to please the companies that give them information


In project management, optimism mixed with
    overconfidence
in their operational ability makes
    often planners
underestimate costs and delays.

Sometimes it is a luck as, if not, there would be too few projects.

Imagine the World without the Egyptian pyramids or the Panama canal.


In the economy in general,
optimism biases and overconfidence
are here also.


=> They entail major mistakes (and some felonies) in
allocating resources.

An example is how corporate presidents are so optimist, and  / or
overconfident in their ability, that they launch inappropriate take
over and mergers
that they overpay and /or cannot efficiently
manage

Even so business optimism might be a luck for society.

There might be fewer business creation and investment, and less
successes by "trials and errors", if people were not a bit overoptimistic
in launching new activities or businesses.

It is mostly their own time and money (or those of people who accepted
to fund their venture) that might get lost.

We might see some involuntary philanthropy here ;-).

Another thing is that differences in social situations influence
personal attitudes
:

Gender seems to play a part:

Some studies have shown that males are usually more optimist and
female more cautious in their decisions.

Other social factors can also intervene: age, wealth, culture,
    occupation.

Why the optimism for business venture
     (and market trading)?

Self-made riches ...hopefully

This optimism about economic prospects for new ventures might rest, not
only on the wish to believe, but also on the common idea among creators
and investors that business creations (as well as stock market trading) are
not gambles, but types of investment offering the best return.

This idea might contain some truth, but mostly:

In the long term,

Only if you avoid the various biases described in this glossary ...and
   also those left out or still undiscovered ;-).

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This page last update: 23/09/15  

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