How Optimism Can Affect Our Financial Decisions Adversely
Research shows optimists make risky investments, gamble, & postpone saving money
Posted Aug 28, 2016
Optimism is a starry-eyed worldview about the future. It affects how each of us sees and responds to people around us and things that happen to us. And it shapes our every decision and action. In previous blog posts, I have described how having an optimistic world-view benefits our health, even helping us recover after a setback. I have also written about a visualization exercise that any of us can do to become more optimistic.
There is one area of life, however, where the net effects of optimism are not necessarily positive. And that is the area of personal finances. The available research shows that optimism’s effects on financial decision making are mostly negative. In this post, I want to consider this research first and then suggest how we can remain optimistic and still handle our finances wisely.
1) Optimists make riskier investments. This is one reason for gender differences in investment decisions.
The strongest evidence for the optimism – risky investment relationship comes from economic studies of gender differences in investing. They find that women invest money more conservatively whereas men prefer to invest in riskier ways. In studying how over 20,000 men and women invested their 401(K) contributions, one study found that compared to men, women kept more of their retirement savings in relatively low-risk fixed income investments like bond funds. They also put much less money in their employer’s stock, typically a riskier investment.
Why? There two reasons for this. The first explanation has to do with risk preferences. Men tend to be less risk-averse than women, so they invest in riskier ways. The other reason, discovered recently by a team of business professors led by Ben Jacobsen, is that optimism plays a role. Women, by and large, tend to be less optimistic than men, which fuels their cautious decision making.
Investing too much retirement money in an employer’s company stock is dangerous. Just consider what happened to hundreds of Enron Corporation employees a decade ago. Having invested all their savings in company stock, many thought they had millions put away for comfortable retirements. But then the company imploded. Virtually all their retirement savings evaporated, leaving many to face unbelievable hardship in their waning years. Despite the horror of this story, riskier investments are not necessarily bad. In fact, over the longer term, investing in a diversified basket of risky assets like stocks consistently is a good thing. As finance professors Vickie Bajtelsmit and Alexandra Bernasek point out:
“All other things equal, a conservative investment strategy results in less retirement income on average than a more aggressive strategy.”
But this is only true if the person saves for retirement consistently, puts retirement savings in a diversified portfolio of risky investments when they are young, and shifts their allocation to more conservative investments as retirement draws closer.
2) Optimists gamble with the aim of winning money. Worse still, they continue gambling even when they are losing.
Where the effects of the optimism – risky investment link are mixed, optimists’ preference for gambling doesn’t have any redeeming aspects at all. A well-cited 2004 study found that optimists harbored more positive expectations about gambling (which the researchers measured using statements like “When I gamble, I expect to win” and “When I lose at gambling, I sometimes keep playing because I am confident I will be able to win back my money”). They were also more likely to gamble in order to win money as opposed to simply having fun. What is more, optimists tended to over-estimate how much they had won in the past, and continued gambling even after they had lost. The authors’ conclusion was:
“Our data do not support, and we do not suggest, that optimists are more likely than pessimists to become involved in gambling. Our data do suggest, however, that optimists are more likely to maintain the belief that they can win at gambling and to persist in gambling following losses.”
As the paper’s title indicates, a preference for is one clear-cut downside of optimism.
3) Optimists defer saving money to the future.
Of all the negative effects on optimism on financial decisions, this last one has the potential to produce the most long-term harm to the most number of people. In my own research with Leona Tam, we studied how optimism affects saving. What we were studying is people’s decisions about how much money to save, and the role of time frames in influencing these decisions.
When participants were asked how much they would save next March vs. how much they would save next month, they gave significantly higher estimates for next March (or other future months): $393 for next month vs. $841 for next March. Why? When thinking about the more distant future, people were more optimistic, thinking they would save more money then. But when the time actually came, they saved even less money than those who were only thinking about the next month.
Optimism is also one reason why Americans tend to save less money than, say, the Chinese. In other research, Leona and I have found that Americans tend to believe in their future progress and success, and think they will have higher income in the future then they do now. So they postpone saving money right away, and fall into the trap of “perpetual saving deferral.”
We can be optimistic and financially prudent at the same time.
The key to being both optimistic and financially savvy is to focus on the present. While an optimistic outlook provides us with a rosy outlook, it also turns our minds towards the future. As we have seen, when making decisions about money, a future-focus can be harmful.
The trick is to shift our focus away from the future and back towards our present. There are many ways to do this. The Chinese do this by adopting a “cyclical mindset” that emphasizes the aspects of life that repeat. When Americans adopt this circular way of thinking, they also save more money.
Fortunately for us, once our attention locks in on the present, optimism produces benefits again. It helps us see the positive aspects of the possessions and the relationships we already have. Retail therapy no longer seems necessary to alleviate the negative feelings from a bad day. Instead, there is a sense of contentment. In such a mental state, it is easy to make prudent decisions about spending and saving money.