Optimists Beware! An Examination of the Practical Implications of the Optimism Bias

Aside from downright greed, what other factors could have caused the financial crisis in 2008? This financial crisis is touted as one of the worst in history since the Great Depression. It shut down banks and financial institutions and caused thousands of people to lose their homes - while at the same time made a small group of people that foresaw the impending decline extremely wealthy. Some argue that over-optimism also known as the optimism bias is to partially to blame.

As humans, we have the luxury of cognition which includes the ability to look forward and make estimations or predictions. However, when we do this, we are typically overly positive in our estimations.

This is over-optimism or the “optimism bias”. The optimism bias is defined as the difference in a person’s expectation and the outcome that follows. If the expectations are better than reality, the bias is optimistic; if reality is better than expected, the bias is pessimistic (Sharot, 2011). This is related to but different from overconfidence/egocentric bias which is an inflated sense of confidence in the accuracy of one’s knowledge and/or cognitive estimates (Russo & Shoemaker, 1992). Optimism and overconfidence are often studied together as they are interrelated when it comes to topics such as entrepreneurship and project planning. It is important to distinguish between the two biases. Overconfidence refers to an inflation of one’s ability whereas over-optimism focuses on the positivity of the outcome. This article focuses on over-optimism.

In business, we count on leaders to steer employees and the company in the right direction. When it comes to biases of any kind, we often don’t know we have them. This is often the case for overoptimism. Business leaders want their new product to be successful, for example, so they overestimate its potential success and draw a blind eye to potential pitfalls (e.g., Pepsi A.M, pictured right). In 2008, banks and financial institutions held an optimistic view that the property markets in different American cities would rise and fall independently of one another. In other words, they knew they were taking a gamble but believed optimistically that it would work itself out. Instead, one of the worst financial crises in America to date took place.

The optimism bias is one of the most prevalent, consistent and robust biases documented in psychology and behavioral economics.

We, as humans, tend to overestimate the likelihood of positive events (Sharot, 2011). In an informal experiment in class with my doctoral cohort, students were asked to pick a card from standard deck, the goal was to pick a high card (nine or higher). Before picking the card, they were asked to predict what their card would be. Out of eight participants, seven predicted optimistically (and none predicted correctly), see results pictured below.

During the financial crisis of 2008, homeowners borrowed much more money than they could actually afford - partly due to the banks approving the inflated mortgages but also partly due to over-optimism. The over-optimism bias has been linked with overborrowing - people tend to borrow more than they would if they accurately perceived the risks they face (Hynes, 2004). In addition, borrowers underestimate the chance that they will suffer some setback, such as unemployment, divorce or illness, that will make repayment difficult or impossible (Hynes, 2004).

Langabeer and DelliFraine (2011) surveyed 168 chief executive officers (CEOs) from the private healthcare industry. The survey measured the optimism level of the CEOs as well as the strategic decision-making processes within their organization asking such questions as “to what extent do you (the CEO) emphasize judgment and intuition versus an analytical reasoning in your firm’s strategic decision process” using a one to five Likert scale. The results show that optimism influences the strategic decision making processes within organizations. Specifically, CEOs that are overly optimistic rely on judgment and heuristics compared to less optimistic CEOs that rely on rationality and analyses.

Meyer (2014) conducted an experiment that examined the extent to which decision makers suffered from optimism bias when it came to projects that were failing. Participants were presented with a project that is significantly over budget, behind schedule and already losing money. Participants were asked to make a determination to proceed with the project or not and asked about the motivation for their decision, this tested their level of optimism about the project. The results revealed that decision makers become more committed to projects as the project progresses even if it is over budget. Part of this is due to optimism bias, participants believed optimistically that the finished project would yield better returns - above what was originally predicted at the start of the project.

Forecasting is affected by over-optimism as shown by Rajapakse and Siriwardana (2007) in their study that examined forecasts of the Australian dollar. The authors found that forecasters tended to overestimate the value of the Australian dollar, especially when there was a depreciation of it. The forecasters argued that the depreciation was unwarranted and that the actual value of the dollar was higher. Regardless of how the dollar was performing, the forecasters believed the dollar would recover and focused optimistically on its upward movement. Overall, the study found there was an 8 percent upward bias on average and about two-thirds of that was due to the optimism bias of the forecasters.

Optimism bias is one of the most prevalent biases that humans exhibit, even rats and birds have been found to exhibit an optimism bias during experiments (Sharot, 2011). Although the potential negative effects of the optimism bias have been focused on, there are also benefits. Successful managers tend to be more optimistic in their forecasts and subsequently exert extra effort to meet their over-optimistic forecasts. This extra effort then leads to enhanced performance therefore optimism is linked to improved firm performance (Hilary, Hsu, Segal & Wang 2016). In addition, a large body of psychology research has focused on the benefits of being optimistic, essentially the power of positive thinking which some claim helps guide people to work toward their relationship and career goals rather than withdrawing and feeling hopeless (Tenney, 2015). Still, much of the research when it comes to business and optimism cautions against being too optimistic. Tenney (2015) specifically looked at whether or not being optimistic affects performance and found that optimism can have a positive effect on things like mood but that other factors such as competence or general mental ability play a much larger role when it comes to performance.

Like with any bias, being aware they exist is important. In a business context there are other ways aside from awareness to help mitigate the potential negative effects of the optimism bias. Lovallo and Kahneman (2003) outline a few strategies in their article titles “Delusions of Success: How Optimism Undermines Executives’ Decision” in the Harvard Business Review. The authors suggest a more objective forecasting approach that includes referencing past projects as a benchmark for current projects as well as looking at outcomes from these projects and estimating where your project falls and assessing your prediction for its reliability (your intuitive prediction vs. the actual).

It beneficial to have a key group of advisers that come from various backgrounds and experience involved in planning and decisions to ensure that a more realistic view is being considered. Another way to mitigate the optimism trap is to conduct an exercise that specifically looks at the risk of a project, product, policy, etc. This is common in project management to ensure that, for example, product developers, aren’t smitten with their design and not seeing potential pitfalls.

Optimism isn’t all bad and certainly has a place - no one wants to be negative or be around negative people. A healthy dose of optimism counterbalanced by a dose of realism and an outside view can make for a good working environment and hopefully better decision-making.

Why do I post articles like this? As a doctoral student I read a lot. Like a lot, a lot. I also like to write. Given the combo of reading + writing, I thought I would start to share some of the ideas on LinkedIn. After all, my doctoral program aims to bridge the gap between academia and business. If there is a topic (e.g., leadership, team building, gender, innovation – you name it) you are interested in, I would love to hear about it! Feel free to message me.

REFERENCES

Cooper, A. C., Woo, C. Y., & Dunkelberg, W. C. (1988). Entrepreneurs' perceived chances for success. Journal of business venturing, 3(2), 97-108. 

Cossette, P. (2014). Heuristics and cognitive biases in entrepreneurs: a review of the research. Journal of Small Business & Entrepreneurship, 27(5), 471-496. 

Hilary, G., Hsu, C., Segal, B., & Wang, R. (2016). The bright side of managerial over-optimism. Journal of Accounting and Economics, 62(1), 46-64.

Hynes, R. M. (2004). Overoptimism and overborrowing. BYU L. Rev., 127. 

Langabeer, J. R., & DelliFraine, J. (2011). Does CEO optimism affect strategic process?. Management Research Review, 34(8), 857-868. 

Lovallo, D., & Kahneman, D. (2003). Delusions of success. Harvard business review, 81(7), 56-63. 

Meyer, W. G. (2014). The effect of optimism bias on the decision to terminate failing projects. Project Management Journal, 45(4), 7-20. 

Rajapakse, S., & Siriwardana, M. (2007). Over-optimism bias in market analysts' forecasts: The case of the Australian dollar. Journal of the Asia Pacific Economy, 12(1), 103-113. 

Russo, J. E., & Schoemaker, P. J. (1992). Managing overconfidence. Sloan management review, 33(2), 7. 

Sharot, T. (2011). The optimism bias. Current biology, 21(23), R941-R945. 

Tenney, Elizabeth (03/01/2015). "(Too) optimistic about optimism: The belief that optimism improves performance". Journal of personality and social psychology (0022-3514), 108 (3), p. 377.