Optimism bias is the inclination of people to believe that they are more likely to be successful than others, and less susceptible to adverse events than others. A well-known example of optimism bias is that, when surveyed, the vast majority of car drivers believe they are better drivers than average, and less likely to have an accident than other people.

It is not clear why humans came to be so unrealistically optimistic. However, research does suggest that optimists live longer and happier lives. An optimistic outlook may therefore increase the odds of survival.

People who are mildly depressed tend to see the world as it is, rather than as an optimist would like it to be. But most people would prefer optimism to depression, notwithstanding the fact that their subjective overconfidence tends to override objective reality.

Optimism bias is greater when people are faced with an event that they can control, such as making an investment. It is lower when confronted with a situation that cannot be controlled, particularly if the situation may have serious negative consequences.

Now the good news is that when we are aware of the illusion of optimism, the brain can take this into account when making a decision. Prior to making an investment decision, reflect upon the distortion caused by optimism. For example, be aware that you are probably not more skilled or knowledgeable than most other investors.

21 March 2016 Macro