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Optimism bias: Our overconfidence in the markets could be our undoing

Overconfidence is an affliction that people in general – and financial advisors in particular – suffer from

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Are you an above average driver? What about love making? Are you better than most, worse than most or about average?

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Surveys have shown 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, we all can’t be right. By definition, about half the people in any given sample will be below average.

The behavioural economics breakthroughs of past 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 nearly anything. But no matter how much they try, only about 50% will be better than 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 drawdown is not only severe, but 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.

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As I write this in mid-June, I confess that I just don’t see it. I also didn’t see requisite caution prior to the dot.com bubble at the turn of the millennium, and I didn’t see it before the global financial crisis of 2007-2009.

Advisors are naturally optimistic people who play an important role in keeping clients calm and focused on the long term.

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 embedded 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 clients 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 your 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.

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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 persuade existing clients to pump the brakes and nearly impossible to recruit new clients while taking a more sanguine stance.

Telling people to be cautious is not conducive to getting them to send you money.

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 unconscious ones. 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, yet not questioned their own skills.

How many financial advisors do you suppose would volunteer to be guilty of optimism bias? If you ask advisors whether they are optimists, most would happily volunteer that yes, yes they are. If you were to ask them, however, whether 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 nothing 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 weren’t so darned optimistic.

John De Goey is an IIROC-licensed portfolio manager with Wellington-Altus Private Wealth (WAPW) in Toronto. This commentary is the author’s sole opinion based on information drawn from sources believed to be reliable, does not necessarily reflect the views of WAPW, and is provided as a general source of information only. The opinions presented should not be relied upon for accuracy, nor do they constitute investment advice. For proper investment advice, please contact your investment advisor. John De Goey can be reached at john.degoey@wprivate.ca

John De Goey
John De Goey

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