Module 12 Innerworth — Mind over markets

Chapter 383

Unrealistic Optimism and Misperceptions of Risk

An on-going controversy among psychologists concerns the benefits of optimism.  Some psychologists argue that optimism is always beneficial, while other psychologists point out that extreme levels of optimism may be associated with biased and inaccurate estimates of negative outcomes.  As highlighted in our Innerworth feature articles and Insights and Attitudes sections, there are clear advantages to holding an optimistic attitude.  Rather than limit your success, it is useful to have a positive attitude, and believe that life offers one endless opportunity for success.  Why limit yourself by thinking that you will experience unfavourable events? Well…it depends on the accuracy of your perceptions.

 

A crucial distinction can be made between realistically estimating the probability of favourable events and unrealistically believing that favourable events will occur when they are unlikely to occur.  Realistic optimism is more useful than unrealistic optimism.  For example, if you have a very poor trading strategy, it isn’t realistic to believe that it will produce profits over a long series of trades.

Unless one carefully and objectively monitors the success of a trading strategy and determines it’s an actual success, the equity in one’s account can be rapidly depleted.  A realistic estimate must be calculated and a new strategy must be developed should the estimate reveal the trading strategy is unprofitable.  One may hold optimistic beliefs, but they must be accurate.  Unrealistic optimism may lead to not only inaccurate estimates of failure but inaction regarding necessary precautions to prevent such failure.

A recent study by Radcliffe and Klein illustrates the disadvantages of unrealistic optimism.  Participants were asked to estimate the probability that they would experience an unfavourable outcome, in which an “objective” estimate of the actual probability was known.  Unrealistic optimists underestimated the probability of the unfavourable event compared to realistic optimists. 

They also allowed their unrealistic optimism to influence their behaviour.  When presented with information regarding how they could reduce the probability of the unfavourable event, they did not review it closely, compared to realistic optimists.  In addition, unrealistic optimists did not show proper concern and did not take the necessary steps to move the probabilities in their favour.

These findings illustrate how optimism sometimes reflects a “defensive” motive to protect one’s self-esteem.  Rather than developing realistic expectations of an unfavourable event, and taking proper precautions to decrease the occurrence of the event, unrealistic optimists ignore important information that may signal a downfall.

Too much optimism is unrealistic, yet too little optimism can be very self-limiting.  It’s critical that you find the right balance between realistic self-motivating optimism and unrealistic biased optimism.  Make sure that you are using optimistic beliefs to your advantage.

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