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Be Cynical, Be Very Cynical
Are you an optimistic person? Do you live life “sunny side up”? If yes, that’s wonderful; however, it may surprise you to know that your infectiously positive personality might be impeding your ability to make successful investments
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Are you an optimistic person? Do you live life “sunny side up”? If yes, that’s wonderful; however, it may surprise you to know that your infectiously positive personality might be impeding your ability to make successful investments.
Studies have indicated that as many as four out of five people suffer from a rather surprising fallacy known as the ‘optimism bias’. This is precisely what fools us into believing that “bad things happen to other people”. It would appear that the vast majority of investors have a tendency to overrate their abilities, transgressing all too often from the “zone of rationality” to the “zone of over-confidence” as a result.
Heather Lench, associate professor and head of department of psychology at Texas A&M University proved this bias in a study titled ‘Automatic Optimism’, during which she discovered that people are, in general, one-and-a-half times more confident that they would encounter positive life events than negative ones.
Here is the more interesting observation: when put under time pressure, people became twice as confident of encountering positive life events than negative ones. Optimism seems to be our instinctive response; and the pressure to take time-bound investment decisions only serves to amplify this tendency.
The real reason the optimism bias is dangerous is because it promotes poor decision making and misjudgement. Blindsided against potentially severe market risks even when negative indicators are staring them in the face, over-optimistic investors are the first to burn their fingers severely during the early stages of a bear market.
Think of the hordes of investors who deployed money during the peak of the equity bull market in late 2007, cheerfully ignoring the loudly tolling global warning bells and the overextended Nifty P/E Ratio of close to 28X.
In fact, the root cause of the optimism bias lies in the illusion of control; the mistaken and often quixotic inner belief that we can influence random outcomes that we actually cannot. Further, there are five conditions that amplify this illusion of control: a high availability of information (business news channels), early success at a task (beginner’s luck), a personal stake in the matter (money), familiarity (your trusted trading terminal), and the availability of many choices (nearly 4,000 listed stocks to choose from). When you think about it, all these factors practically define the environment of stockmarket investing! It is no wonder then that irrational optimism kicks in at a moment’s notice. As a result, investors regularly mistake randomness for control; often leading to colossal judgement failures and crushing portfolio losses.
Benjamin Graham, widely accepted as the father of value investing, observed that “chief losses to investors come from the purchase of low quality securities at times of favourable business conditions”. In other words, irrational exuberance about current occurrences clouds their ability to make sound decisions about the future.
The optimism bias is admittedly hard to overcome, but you could start by taking lessons from successful investors; they tend to be a lot more cynical while selecting investments than the general investing populace.
Learn to make “no” your default response to new investments, and aim to collect facts that prove otherwise. If you play it the other way around, you run the risk of trying to mould reality to fit your own sanguine viewpoint. By becoming a critic, you will be concentrating your investments into high-conviction bets instead of spreading yourself too thin. You will also be greatly reducing the odds of catching a bull market by its tail!
So, the next time you find yourself ready to make a brave investment against common sense and sound logic, and that reassuringly optimistic voice in your head whispers “this time it is different”; silence it and walk away. It almost never is.