Becoming a Better Investor:  Overoptimism Tendency

Charlie Munger, the legendary investor and longtime Berkshire Hathaway Vice Chairman, has some of the best advice on how to invest and make long-term gains. He highlighted the powerful role human psychology plays in shaping our decisions, whether it’s related to life or the way we invest. He identified 25 key psychological “tendencies” that influence behavior. He believed that by identifying these latent biases, investors can avoid the mistakes that come with it and make smart, informed and rational choices.

This week, we’re looking at the thirteenth tendency, the Overoptimism Tendency, and how this can have a negative impact on investments. 

What is it?

Charlie Munger's "Overoptimism Tendency" refers to the human tendency to be unrealistically optimistic about situations. He describes it as the human brain’s inherent inclination to overestimate the likelihood of positive outcomes.

To quote Munger,

“About three centuries before the birth of Christ, Demosthenes, the most famous Greek orator, said, ‘What a man wishes, that also will he believe.’ Demosthenes, parsed out, was thus saying that man displays not only Simple, Pain-Avoiding Psychological Denial but also an excess of optimism even when he is already doing well.”

This cognitive bias drives people to believe they are more capable, more lucky, and more likely to succeed than logic or data would suggest. In investment and other ventures, this bias can lead to misjudgments, like ignoring the risks involved in a particular situation, or believing investments will recover, even when the facts say otherwise.

How does it play out in the world of investing?

A certain degree of optimism is necessary in investing: none of us would risk capital in a company without believing in its potential. However, we can’t let this emotion be what guides all our investment decisions. When we move from “optimism” to “overoptimism,” we expect unrealistic outcomes. We look at the best-case scenario all the time, get overconfident in choosing where to invest, underestimate the competition, and ignore what the market, facts, and logic may be telling us — and risk losing money in the bargain.

The antidote to overoptimism is pragmatism.

• Ask what could go wrong: Instead of focusing on only what can go right, we need to think about what could go wrong and seek out disconfirming evidence, so we can uncover those blind spots and confront unpleasant truths.
• Stick to the zone of competence: Overoptimism tends to arise when we venture into areas we don't fully grasp or understand. And this lack of understanding is when we ignore or don’t factor
• Use a checklist: It’s always good to have a checklist in place, with details on why we chose  to invest in a company, along with the potential downsides/factors that may force us to let go of the investment. A checklist can mitigate emotional decision-making by ensuring that critical risk factors are taken into consideration.

We don’t have to be pessimistic, but we need to look at things long-term and not just from the point of view of quick gains. Being overoptimistic can lead us to chase short-term trends, ignore the fundamentals, and hold on to loss-making investments for far too long.

When we acknowledge the dangers of overoptimism and build guardrails around our investment process, we can protect ourselves from costly mistakes.

Sources

https://fs.blog/great-talks/psychology-human-misjudgment

https://wisdomfromexperts.com/overoptimism-tendency