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OpEd
Investing 101
The Guestroom

Optimism and Overconfidence in Asset Allocation Decisions

by Shlomo Benartzi, Daniel Kahneman, and Richard H. Thaler | There's no doubt that people tend to be overly optimistic. For instance, most people believe deep down that they are less likely to get hit by a bus or to be mugged than their neighbors are. Such optimism isn't necessarily bad; it lets people cope with life's uncertainties. However, optimism can have an adverse effect on investment decisions if people set unrealistic expectations.

Most people are also overconfidant in their own abilities. For instance, surveys show most people think that their driving skills and social skills are better than average. Similarly, 81% of new business owners believe their business has at least a 70% chance of succeeding, but only 39% think that any business like theirs is likely to succeed. Overconfidence, like optimism, is not necessarily bad. For example, it helps soldiers cope with war. However, overconfidence can lead to substantial losses when investors overestimate their ability to identify the next Microsoft

MSFT or Amazon AMZN.

In a recent survey on Mornigstar.Net we examined how optimism and overconfidence apply to individual investors. We were particularly interested in how optimism and overconfidence affected forecasts of stock-market performance. We were also interested in whether optimism and overconfidence affect actual investment decisions.

Before we turn to the questionnaire and the results, we'll briefly describe the 1,053 Morningstar.com subscribers who completed the survey. Most of them are male (84%), their average age is 45 years old, and their reported annual household income averages $93,402. Most of the respondents invest aggressively: The average allocation to stocks is 79%, and half of the people allocate at least 95% of their retirement contributions to stocks. As these figures suggest, this is not a random sample of the population, and the results we report should be interpreted with this in mind.

To measure optimism, we included the following question in the survey:

In thinking about financial decisions, do you spend more time thinking about the potential return or the possible loss?

A Much more time on potential positive return 39%
B Somewhat more time on potential positive return 35%
C Evenly on both 19%
D Somewhat more time on possible loss 6%
E Much more time on possible loss 1%

Answers A and B indicate optimism, whereas answers D and E indicate pessimism. Thirty-nine percent of the subscribers spend much more time on potential positive returns (answer A), whereas only 1% spends much more time on possible loss (answer E). Similarly, 35% of the subscribers spend somewhat more time on potential positive return (answer B), whereas only 6% spend somewhat more time on possible loss (answer D). We conclude that most people are optimistic.

The survey also included a question regarding the likelihood of stocks outperforming bonds in the "long run." The specific question went like this: "What do you think is the likelihood of stocks outperforming bonds in the 'long run' (i.e., over a period of 20 years or so)? Please enter the percentage likelihood of stocks outperforming bonds."

Those who are extremely optimistic are expected to be certain that stocks will outperform bonds, whereas those who are extremely pessimistic are expected to seriously doubt the future performance of stocks. On average, subscribers believe that the likelihood of stocks outperforming bonds is 85%. Details on the range of responses are presented in the first graph below. Interestingly, one third of the Morningstar.com subscribers believe that the likelihood of stocks outperforming bonds over the long run is 100%. In other words, they are convinced that there is no chance whatsoever that stocks will underperform bonds. This is what we mean by optimism.



Note that the estimates in the graph are spread all over the place, ranging from zero to 100%. How can it be that some think there is no chance stocks will outperform bonds, whereas others think stocks are absolutely guaranteed to outperform bonds? Can they all be correct? We interpret the wide range of estimates as evidence that people pay lots of attention to their own estimates and very little attention (if any) to what other people think or to the consensus estimate. This is what we mean by overconfidence about one's opinion.

Last, we wanted to find out whether a combination of optimism and overconfidence affects the actual investment behavior of Morningstar.com subscribers. To answer this question, we compare individual estimates of the likelihood of stocks outperforming bonds with asset allocation information. The results of this analysis are presented in the second graph. In general, as the estimated likelihood of stocks outperforming bonds increases, so does the allocation of retirement contributions to stocks. For instance, those who are bearish (i.e., those who believe the likelihood of stocks outperforming bonds is 0-24%) allocate 57% of their retirement contributions to stocks, whereas those who are bullish (i.e., those who believe the likelihood of stocks outperforming bonds is 100%) allocate 84% to stocks.



In summary, it appears that individual investors tend to be overly optimistic. They tend to focus more on potential positive returns than possible losses, and roughly a third of the people we surveyed believe that stocks are definitely guaranteed to outperform bonds over the long run. We wonder whether those overly optimistic investors understand the risk and return profile of their portfolios.

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Shlomo Benartzi, Daniel Kahneman, and Richard H. Thaler are leading figures in the field of behavioral finance.

 

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