How Pessimism Bias Could Be Negatively Affecting Your Investments
What is pessimism bias?
Pessimism bias is a cognitive bias that leads people to believe that bad things are more likely to happen than good things. Not that bad things don’t happen or happen often, it’s that people who suffer from pessimism bias believe bad things will happen more than 50% of the time, -most, significantly higher than 50% of the time. Worse yet, pessimists also get extremely suspicious when positive things are happening and will say “all good things will come to an end”.
Why is pessimism bias important to know and understand?
According to Elizabeth Scot, PhD in an article for verywellmind.com, “overly negative thinking contributes to depression and anxiety. It can lead to greater risk of heart disease as well as overall mortality”. However, she also mentions “healthy doses of pessimism can prepare you better for tougher times”, which is why it’s so important to be aware of all possible outcomes, but have a good understanding of probabilities.
How does pessimism bias affect our investment choices?
Higher pessimism levels can have a significant effect on your financial plan and long-term investment results. People who struggle with pessimism bias are more likely to make poor investment choices due to their negative outlook on the future and can consistently miss good investing opportunities. It’s really quite simple - if you believe bad things are going to happen, it’s hard to see a reason why you would buy or hold stocks. You’re also more likely to sell investments instead of buying them when the timing is more in your favor. If you read last month’s bias blog on Recency Bias, you’ll remember that we have a tendency to believe whatever just happened will most likely continue to happen. If the market were to go down 20%, recency bias would cause us to believe it will continue and pessimism bias can amplify that with negative feelings. Next thing you know, the market recovers and you didn’t take advantage of a 20% drop in the market.
How can we manage pessimism bias?
In order to overcome the pessimism bias, you first have to be aware it exists and believe you could be susceptible to it.
I suffer severely from pessimism in certain areas of my life. I’m always scared something bad will happen to my kids and I’m always being more cautious than I probably should be. This causes more stress and anxiety in my life than warranted.
Always try to counter it with positive thinking.
When making investment decisions, it is important to be optimistic about the future and to believe that good things can happen. If you can’t acknowledge good things can happen or ignore the long-term statistics of market positivity, there is a strong chance you’ll struggle to get the returns you need and achieve the long-term goals of your financial plan.
Another way to overcome pessimism bias when making investment choices is to seek advice from others.
When you get input from an outside perspective, you are more likely to make better decisions. The challenge with this is finding those with alternative views (many in fact) to help make the best well-rounded decision.
Zoom out!
We get pounded with negativity and reasons to sell or not invest, zooming out can help remind us what happens over the long-term and why we decided to invest in the first place.
As with anything, balance is key. You need to know what the negatives are and how they can impact your financial plan but we must balance those with the statistical probability of long-term positive results. Mark Cuban once said, “it doesn’t matter if the glass is half-empty or half-full. All that matters is that you’re the one pouring the water”.
Keep pouring the water!
Shean