In a study entitled “Optimism and Economic Choice”1 researchers used the extensive data provided through the Survey of Consumer Finances (SCF). The SCF is sponsored by the Federal Reserve Board in cooperation with the Department of the Treasury and is conducted every three years to provide detailed information on the finances of U.S. families.
The data gathered includes information on employment status, retirement plans, portfolio holdings as well as life expectancy and lifestyle.
The anticipated life expectancy expressed by participants was compared to life expectancy based on actuarial tables. As a group, the expectancy was surprisingly close to the tables; however, there was a wide spray of responses. Optimists were defined as any participants who anticipated life expectancy longer than that implied by the statistics. Extreme optimists are those who anticipated living substantially longer than the statistical tables, while moderate optimists anticipated living only slightly longer.
When you think about it, some of the most important economic decisions we face occur relatively infrequently – vocational choices, marriage (or re-marriage), retirement. Therefore, we are ripe to be influenced by emotions and attitudes rather than data.
The researchers looked at some economic characteristics of each group of optimists and found that moderates tend to save more, spend less, smoke less, pay off credit cards, work longer hours, expect a later retirement and invest in stocks, but chose pooled products rather than individual securities or day trading.
Those extreme optimists, on the other hand, tend to save less, spend more, smoke more, carry large credit card debt, assume they will work forever (but work shorter hours) and tend to be day traders or individual stock pickers.
It’s something like red wine – a bit is good, but a lot is not! To invest in the stock market, we must be moderately optimistic - we have to be able to assume some risk. But if we are too optimistic there is more likelihood of over-estimating the possibilities and, looking through rose-coloured glasses, we see only favourable events. The overly optimistic investor may hold too much equity and be unable to expect the unexpected.
In the world of behavioural finance, there is a distinction between overconfidence and optimism. Wikipedia defines each as follows:
The overconfidence effect is a well-established bias in which someone's subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high. For example, in some quizzes, people rate their answers as "99% certain" but are wrong 40% of the time.
Optimism bias is the demonstrated systematic tendency for people to be overly optimistic about the outcome of planned actions. This includes over-estimating the likelihood of positive events and under-estimating the likelihood of negative events.
At PWL, we encourage moderate optimism. But we are fully aware of the need to construct our portfolios with the unexpected in mind.
1 Puri, Manju and Robinson, David T., Optimism and Economic Choice. Journal of Financial Economics (JFE), 2007. Available at SSRN: http://ssrn.com/abstract=1010023