Moneymentals | Our Blog
- Created on 06 December 2011
- Written by Michael Goldman
Humans are an optimistic breed. We believe we can defy the odds and control our own destinies. When we’re told that about half of all marriages end in divorce, we’re still convinced we’ll live happily ever after. When we’re told that 80% of new businesses fail, we’re confident our startup will be the one in five that survives. When we’re told we’re more likely to be struck by lightning than win the lottery, we say, “Well, somebody has to win!”
It’s as if we’re born with rose-colored glasses pasted to our retinas. Though we usually don’t recognize it, we carry with us a persistent optimism and an illusion of being in control, andthese can lead to faulty financial decisions.
Optimism and Overconfidence
Most people have a positive view of their abilities and prospects of success. This personal bias toward optimism and overconfidence is a fundamental finding in behavioral economics.
Here’s a classic example: If people are asked to rate their driving ability, 75% to 80% think they’re above average. The same goes for almost any other domain: sense of humor, entrepreneurship, success in marriage, profession, grades and so on. Depending on the study, 75% to 95% give themselves above-average ratings, although by definition half should be above average and half below.
Such overconfidence is DNA-coded. If we weren’t so optimistic, we probably wouldn’t be motivated to do much of what we do—to try different options, innovate, make changes for the better—because we wouldn’t have hope. We need optimism to push past inertia, even when it comes to raising kids or getting out of bed in the morning.
Illusion of Control
In addition overconfidence, we tend to have an almost irrational sense of how much control we have over circumstances. We actually think we can influence outcomes when we have no control! For instance, people are willing to pay four times as much for a lottery ticket so they can pick the numbers, even though winning numbers are selected absolutely at random. Do we actually believe that picking numbers ourselves makes us more likely to win?
Early success strengthens the illusion. For example, one study showed that people who correctly guessed the outcome of several early coin tosses rated themselves as much better guessers than those who’d started badly. Illusions of control also increase when you have many choices, the task is familiar, there’s a lot of information and/or you’re personally involved.
Resulting Money-Management Decision Errors
Our optimism and false sense of control are not necessarily bad. However, here are ways they can keep us from making good financial choices:
- Interpreting lucky investing decisions as skill: Illusions of control can flourish in an investing environment. Sometimes we make a lucky guess and then believe we controlled the outcome, only to find that the next outcome is disastrous because we never had control in the first place.
- Banking on successes in real estate: During a real estate boom, a friend of mine purchased a condo that quickly doubled in value. He tried to repeat his success just in time for real estate to crash. Thinking we’re in control due to an early success, an abundance of information and personal involvement with a familiar task can lead to bad places.
- Having a low or nonexistent emergency fund: Feelings of optimism and control can make us think life will always treat us well. For example, if we think we’re so proficient at our job that we won’t get laid off or our car was such a perfect choice that it won’t break down, we might underprepare for a layoff or car trouble. It’s dangerous to skimp on a 911 fund.
- Underestimating the need for insurance and estate planning: Thinking, “It won’t happen to me,” when it comes to severe health problems, disability or an untimely death can lead people to remain uninsured or underinsured. Many put off creating a will and pass a lot of stress to their loved ones after they’re gone.
Hope is essential for a happy life. Depression research shows that depressed individuals aren’t necessarily irrationally down, they’re just not as irrationally optimistic as the rest of us!
Perhaps the best antidote to the error of overconfidence is following the old adage to hope for the best, but prepare for the worst—with a bit more emphasis on preparing!