Cheer up, Brian. You know what they say: some things in life are bad. They can really make you mad. Other things just make you swear and curse. When you’re chewing on life’s gristle, don’t grumble; give a whistle, and this’ll help things turn out for the best. And… always look on the bright side of life…
Monty Python’s Life of Brian
When I was in the Army and stationed in Germany, I tried to take as many trips as possible.
I didn’t really have the paycheck to afford those trips, but I took them anyway, and let my credit card bear the brunt of the difference.
I figured, after all, that I was going to get promoted, get pay raises, and then I would have the cash flow to pay for my profligacy.
The same mindset occurred when I went to graduate school. Go into debt to pay for the education, then get a much better paying job after graduation, which would help pay for the student loan, and, oh by the way, a nicer lifestyle.
This mindset is actually very prevalent in the human mind. It turns out, as research from University College of London’s Tali Sharot shows, that healthy individuals who do not suffer from depression predict positive events to be more likely than neutral or negative events. This tendency is called optimism bias.
Optimism bias manifests itself in many ways.
Research from Canterbury University’s Hamish Seward and Simon Kemp showed that psychology students overestimated their future income. They overestimated incomes in two ways. First, they overestimated how much they thought the average income of their classmates would be in 10 years. They thought that their classmates would average $40,000 in annual income 10 years after graduation, whereas only 35% of average New Zealanders with a college degree earned that much. Furthermore, they estimated their own average income – what each respondent would personally earn – as $10-15,000 more than what they thought their classmates would earn. Apparently, those psychology students lived in Lake Woebegone, where everyone was above average.
The original research that led to the coining of the optimism bias term came from Daniel Kahneman and Amos Tversky, who noted that people were more willing to insure against moderate risks than against large risks. In other words, they had the insurance equivalent of thinking that tornadoes only hit other people’s homes.
How Optimism Bias Affects Our Personal Finances
Whenever I think of how we tend to be overly optimistic, I think of the parody about real estate.
Yet, in reality, it seems that the stock market gets hit about once every 10 years:
- The Great Recession
- The dotcom bubble
- Black Friday
- 70s oil shocks and inflation
You get the point.
We forget about the downside because we have a natural inclination to only think about the upside.
After all, what’s the point of getting out of bed in the morning if you don’t think that the future is going to be as good as or better than the present?
Yet, I imagine, a couple of years after the coronavirus pandemic has passed, we’ll have forgotten all about it.
We see this historically as debt decreases right after a dip and then goes back up again.
However, too much of a good thing is too much. Optimism bias does encourage us to take on riskier behaviors than we normally would, and we’re unprepared for the consequences when they happen.
How can you fight optimism bias and protect your personal finances?
- Avoid debt. I, personally, am a believer that there is no such thing as “good debt.”
- Be properly insured. This includes life insurance, disability insurance, health insurance, and long-term care insurance.
- Don’t take outsized risks with your investments. I recommend taking shots with no more than 5% of your investable capital.
- Have a healthy emergency fund. While most planners think 6 months of expenses is sufficient, you may want to look at having 12-16 months of net expenses in cash and cash equivalents to protect yourself from a big economic shock.
- Evaluate protecting your income stream in retirement. Some options include:
- Having a contingency plan in place before the next shock so that you can simply execute on a predetermined plan rather than reacting in a time of high stress
As George Santayana once said, “Those who cannot remember the past are condemned to repeat it.”
This inability to learn from past negative shocks is particularly prevalent in our personal finances because of optimism bias. As a result, most people are grossly underprepared for wildly negative outcomes, which, from a historical perspective, happen reasonably frequently.
How are you protecting yourself from your optimism bias? Let’s talk about it in the comments below!