In a video interview to Inc. magazine editor Eric Schurenberg, Daniel Kahneman, the Israeli-American psychologist, who won the 2002 Nobel Memorial Prize in Economic Sciences for his work on the psychology of judgment and decision-making as well as behavioural economics, said, “I don’t want my financial advisor to be an optimist. I have absolutely no use for that. Being a conservative investor, I would be very uninterested in somebody with a wild business plan for my wealth." (http://bit.ly/1Pu5fmq)
The pitfalls of an overtly optimistic financial adviser or wealth manager are obvious, especially in the retail segment, where the information asymmetry between a financial adviser and an investor is wide and gaping. Yet, is unfavourable, less-than-prudent optimism the preserve only of financial advisers and wealth managers, dissed as several of them justifiably have been for negligent, misleading advice?
Over the past eight months, I have met more than two dozen senior private bankers and wealth managers as research for my book. For most of them, the new wealthy in India is an exciting client segment for growth. The first-generation wealthy falls in either of these two categories—first-generation business builders who come into considerable personal wealth owing to the equity they have in their companies, and the professional rich, essentially senior executives who gather wealth by the bulge of their salaries, stock options and performance bonuses.
Wealth managers say that the first-generation entrepreneur is the tougher client—ambitious, and aggressive with a higher risk appetite. Having seen an exponential increase in the value of the equity they hold in their companies, as investors, too, their expectations are singed by soaring optimism, impatience for robust growth and an eagerness for their wealth managers to show products and ideas that constantly beat market returns. A senior private banker in Mumbai who advises several new wealthy clients said it’s often an uphill battle to convince clients to be satisfied with a sustained 15% return, and that the bull run of 2003-07 was an aberration. They are more focussed on knowing the returns they are likely to get than in understanding the risks, he added.
Most of us don’t diagnose our optimism appetite enough to understand how it moulds our decisions. Neuroscientist and author Tali Sharot, who has been researching the “optimism bias" in her Affective Brain Lab at University College London, said 80% of people experience the cognitive bias. Her findings show that people have a tendency to overestimate the likelihood of good things happening to them and believe that they are less at risk of experiencing a negative event compared to others. “For example, individuals underrate the chance of getting divorced, being in a car accident or suffering from a major illness, while they expect to live longer than others, overestimate their success in the work force and believe that their children are especially talented," Sharot said in her book, The Optimism Bias: The Tour of the Irrationally Positive Brain.
The abundant optimism bias of entrepreneurs and business builders is often their most powerful tool. It gives them the ability to articulate a new possibility and a new way of doing something, even when the odds of survival, let alone success, might be limited.
But does the brand of strident optimism transport well to the world of investing? Optimism and Economic Choice, a research paper published in the Journal of Financial Economics in June 2007, and written by Manju Puri and David T. Robinson, concluded that although more optimistic people worked harder, expected to retire later, invested more in individual stocks, and saved more, extreme optimists displayed financial habits and behaviour that are generally not considered prudent.
Entrepreneurs don’t hedge their bets: they work on an “all-in" model. Their time, opportunity, capital and risks are all vested in one entity—ventures they have founded. Smart, prudent investing often calls for quite the opposite: careful diversification in separate allocations, studied patience and preferably a higher aversion to risk. Can optimism interfere with this, becoming a threat to guard against?
In a Skype conversation a year-and-a-half back, Sharot had said that when confronted with actual data that might be contrary to their plans and objectives, very optimistic entrepreneurs are likely to dismiss the data. Entrepreneurs, she had told me then, should understand that it isn’t always true that the more optimistic you get, the higher your chances of success; that, at some point, the success-optimism relationship starts reversing. The dangers of optimism that she describes sounds much like the attitude of the clients the wealth manager I quoted above talked about. Maybe, it’s time they underwent an optimism temp-check.
As we begin a new year, do figure out where you stand on the optimism scale, and how it influences your work and money. It might become the difference between great expectations and safe returns.
Shreyasi Singh is former editor of Inc. India. Her first book, on India’s new wealthy and their wealth managers, will be published by Bloomsbury.