Overconfidence leads to Optimism Bias

Teenage Boy Drinking Caffeine Energy Drink Gaming At Home Using Dual Computer Screens At Night

Are you an above average driver?  What about love making?  Are you better than most, worse than most or about average?  Surveys have shown over and over that people tend to overestimate their own abilities.  This tendency has become known as the “Lake Wobegon Effect” as a hat tip to Garrison Keillor’s imaginary land where everyone is above average.  Believing in yourself is just human nature.  Unfortunately, it isn’t possible that we’re all right.  By definition, about half the people in any given sample will be below average.

The Behavioural Economics breakthroughs of the past couple of generations have laid bare what the small library of self-help books has inadvertently created: a western world awash in confident snowflakes who go about their business thinking that if they just try a little harder, they can accomplish just about anything.  The thing to remember is that no matter how much any or all of them try, there will never be much more than about 50% who are better than average.

The one thing that absolutely will not happen is that no matter how hard anyone tries, only about half the strivers will outperform.   It remains a metaphysical certainty that no matter what we’re discussing, only about half the population will succeed at being above average.  The general problem is one of overconfidence, an affliction that many people in general – and financial advisors in particular – suffer from.  If things generally work out – and let’s face it – the bear markets of our generation have not only been few and far between, they have also been relatively short-lived, then people will be fine.  But what if the next draw down is not only severe, but also prolonged?  Then what?


The generic affliction of overconfidence can easily give way to the more insidious affliction of optimism bias in the financial advice business.  In my line of work, the glass is almost perpetually half full.  Some readers might be old enough to remember the old Merrill Lynch commercials: “We’re bullish on America”.  It summarizes the concern neatly.  There’s nothing wrong with bullishness when times are favourable or even normal.  However, when valuations become stretched as they most certainly are now, that bullishness ought to give way to a more careful and cautious approach.  As I write this in late April 2021, I confess that I don’t just see it.  I also didn’t see requisite caution prior to the bubble at the turn of the millennium and I didn’t see it before the Global Financial Crisis of 2007- 2009.  Financial advisors are supposed to help navigate uncertain environments.  They’re supposed to be responsible risk managers.  That’s the story, at least.  Despite this, most financial advisors have an approach that is ‘all optimism all the time’ – prevailing circumstances be damned.  Aren’t fiduciaries supposed to be responsible stewards of their clients’ lifelong capital?  Aren’t there at least some instances where caution and care are warranted as default behaviours?  As far as I can tell, this is no place to discuss normative behaviour.  Whatever it is that advisors OUGHT TO do, it is often not what they ACTUALLY do.


There are two reasons for this: the inherent personality types of advisors and the imbedded value propositions and pre-dispositions of the financial advice business.


The first explanation is simple.  Advisors are naturally optimistic people who play an important role in keeping people calm and focused on the long term.  It has often been said that one of the most critical roles an advisor can play is one of behavioural coach – a person who can get you to do what you need to do to be successful, especially if you natural tendency is to do something else.  It is a micro-level personality trait that is prevalent in the industry and it serves most advisors and most of their clients quite well.  Most advisors come by their optimism naturally and honestly.

The second explanation is a little less innocuous.  Part of why advisors are optimistic is that that’s what their industry expects of them.  Telling people to be cautious is not conducive to getting them to send you money.  Since advisors and their firms always want more money to manage, it would be counterproductive to get existing clients to pump the brakes and nearly impossible to recruit new clients while taking a more sanguine stance.  Basically, optimism bias is simply good for business.


The important thing about biases is that, although we all have them, not everyone functions at the same level of self-awareness.  Stated more explicitly, many biases are known as ‘unconscious biases’.  I suspect many readers would have come across the research saying that around 80% of any given population considers themselves to be above-average drivers.  How many financial advisors do you suppose would volunteer to be guilty of optimism bias?  If you ask advisors if they are optimists, most would happily volunteer that yes… yes they are.  However, if you were to ask them if their optimism constituted a blind spot (i.e. something that they are not consciously aware of and might not be fully considering in the course of doing their job), well, I suspect the number of happy volunteers would drop considerably.


There is absolutely nothing that is necessarily wrong with Optimism Bias of and by itself.  It is both natural and widely understood.  Many consider it to be harmless.  The potential problem is that if you’re getting advice with a friendly smile, a pleasant demeanor and a firm handshake, that comportment might provide comfort and confidence, but it won’t stop you from taking a little more risk than you otherwise might at a time when you otherwise wouldn’t if your advisor wasn’t so darn optimistic.

John DeGoey

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