May 2016

OPINION: Deluding ourselves

Plane wingOptimism bias is a demonstrable problem among investors. Our correspondent in Asia suggests a radical solution.

Everyone agrees it’s good to aim high. But when does optimism tip over into self-delusion? Take the following case.

Funds Global Asia attended a press briefing in Hong Kong hosted by State Street Global Advisors, which had commissioned a survey of 400 institutional investors and asked them, among other things, what return they expected from their portfolios over the next five years.

The respondents gave an average answer of 10.9% a year.

Yes, you read that right. On average, these investors – which included pension funds, sovereign wealth funds, insurers and asset managers – expected a yearly return that would add two-thirds to the value of their portfolios by 2020 (not accounting for inflation).

A nice return by anyone’s standards. But is this estimate realistic?

At the briefing, State Street’s Kevin Anderson admitted to being surprised by the results. The company recently did its own five-year return forecast – for global equities only – and estimated 5.6% a year. 

So the investors in the survey thought they would get almost twice as much on their overall portfolios as State Street thought global equities alone would yield.

Anderson admitted his firm’s estimate was made in the first quarter, after January’s volatility, while the respondents in the survey had given their answers in the second half of 2015, at a time when, perhaps, many were more optimistic than they are now. Still, in an industry that is constantly telling us how “long term” it is, a difference of a few months between estimates should not lead to such widely divergent outcomes.

What to do? State Street would never say this, of course, but your correspondent’s view is simple: explain to these respondents that they are deluding themselves.

In fairness, the investors have an excuse. It is human nature to expect too much. Numerous studies have highlighted what is called optimism bias, a cognitive effect that causes people to believe they are less likely to experience a negative event than others, and more likely to outperform the average.

The optimism bias is found in people who believe they are less likely than others to be victims of crime, or who think they are less at risk from illness, or – and this is the important one – in traders who believe they are less exposed to losses than others in the market.

Consider this last point when looking at the survey data. How many of these investors factored in the chance of a market correction causing a year or two of flat or negative returns? How could the return targets possibly be met in that case?

Studies indicate optimism bias is very difficult to eradicate. Even when test subjects are warned about the bias and told to account for it, they still exhibit optimism bias in their estimates. (See Thinking, Fast and Slow by Daniel Kahneman for a discussion of this and other cognitive biases.)

Is there anything investors can do to counter optimism bias? Here’s an idea: find someone with the opposite problem, pessimism bias. People with depression, for instance, persistently exaggerate the likelihood that bad things will happen to them.

If you find such a person – the kind who broods constantly on their own misfortune, believes trouble is always around the corner, and brings an umbrella to work on a sunny day – consider employing them. They might just act as an antidote to everyone else’s delusional optimism.

©2016 funds global asia

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