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
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?
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.
