- Are you above average at your job?
- Are you above average at making love?
- Are you an above average driver?
The vast majority of people answer yes to these three questions, which of course cannot be correct because half must be below average. By answering ‘yes’ you have displayed overoptimism.
The tendency to overrate our abilities is amplified by the illusion of control – we think we have more control over outcomes than we actually do. For example, did you know that people will pay four times more for a lottery ticket if they pick the numbers themselves, versus having a computer randomly pick the numbers for them? The act of picking numbers yourself does not make them any more likely to occur yet most people place a premium on the option.
Optimism seems to be the default state for most of us, but why?
Scientists suggest that optimism presented some kind of evolutionary advantage. Searching far and wide for food, hunting wild animals and other similar activities once performed by our ancestors involved taking risks (see this link for more information). Pessimists would naturally avoid such risks.
Psychologists have documented a ‘self serving bias’ whereby people are prone to act in their own best interests. Try asking a barber if you need a haircut, or a management consultant if you need some consulting, or a personal trainer if you could do with some one to one workouts if you want to see the self serving bias at work.
The self serving bias is particularly dangerous in investing. If you choose to seek the advice of an expert, be very careful as to whom you choose to listen. The recent financial crisis provides plenty of examples. Just before the market crashed, 91% of analysts rated shares as either ‘buy’ or ‘hold’. At the same time, the ratings agencies, who were funded by the loan issuers they were rating, rated many sub investment grade loans as AAA.
So how do we beat this tendency? We must learn to think critically and be more skeptical. Ask why should I buy this property, not how can I buy this property.