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Over-optimism, superiority bias and the illusion of control

Human beings are not cut out to be good investors. We just aren’t. We’re hard wired to do the wrong things at the wrong times. The secret is to be aware of our behavioural biases and, as best we can, to try to manage them — ideally with the help of an objective third party like a financial adviser.

Search for “behavioural biases” on Google and you’ll find them there are hundreds of them. But, from an investing point of view, which is the most damaging? Which one is most detrimental to our long-term investment returns? In my personal opinion, the costliest bias of all is optimism bias and, closely connected to it, overconfidence.

Of course, as with all behavioural biases, we have them for a reason, and optimism is no exception. People with a positive outlook on life and the future tend to be healthier, both physically and mentally, than those who don’t. Optimism bias helps us cope with life, its frustrations and disappointments. (Trust me, you couldn’t support Aston Villa without it.)

But investing is a classic example of an area in which a tendency towards too much optimism can land us in trouble.

I recently interviewed Lisa Bortolotti, a Professor of Philosophy at the University of Birmingham, and an expert on this subject, for the first in series of videos about behavioural finance, called Your Own Worst Enemy.

Academics, she explained to me, have identified three main ways in which excessive optimism can militate against us when it comes to investing:

the illusion of control, the sense that we have control over something when we don’t;

the better-than-average effect, or assuming that we’re better at something than we actually are; and

unrealistic optimism, or the tendency to underestimate the chances of a negative outcome.

In this video, we look at each of those three factors in turn.

Remember two things in particular while watching it. First, just because you think you aren’t prone to optimism bias yourself, that doesn’t mean you aren’t. It’s one of the characteristics of overly optimistic and overconfident people that they don’t recognise themselves as such.

Secondly, even if you yourself aren’t susceptible to undue optimism and overconfidence, you shouldn’t assume that others you may be paying to help you invest sensibly are immune to it — your financial adviser, for example, or your fund manager.

Optimism bias could be costing you dearly, and the chances are you don’t even know it.