I found the article "The Optimism Bias" by Tali Sharot very interesting.

Our brain is hardwired for hope. The brain evolved over the ages to look positively into the future. Even in bad outcomes our brain tends to find some positive conclusions. There is a neural mechanism that generates optimism:

…these precise regions - the amygdala and the rACC - show abnormal activity in depressed individuals. While healthy people expect the future to be slightly better than it ends up being, people with severe depression tend to be pessimistically biased: they expect things to be worse than they end up being. People with mild depression are relatively accurate when predicting future events. They see the world as it is. In other words, in the absence of a neural mechanism that generates unrealistic optimism, it is possible all humans would be mildly depressed.

I try to draw some parallels with trading. Most traders tend to look positively to news and expect positive outcomes to challenges. This could explain why buying a dip is more successful than selling an expansion of price to the upside. It explains also why crashes catch by surprise the optimistic herd, that continues to look positively into the future although all the elements are there to understand that things are very bad. Only a few "mildly depressed" investors manage to sail macro and micro events maintaining a good understanding of what is going on. (I am not sure whether this is good or bad news because it is not very exciting to be "mildly depressed" in order to make money…).

"How do expectations change reality? ….. To induce expectations of success, she primed college students with words such as smart, intelligent and clever just before asking them to perform a test. To induce expectations of failure, she primed them with words like stupid and ignorant. The students performed better after being primed with an affirmative message". “Expectations become self-fulfilling by altering our performance and actions, which ultimately affects what happens in the future. Often, however, expectations simply transform the way we perceive the world without altering reality itself.”

The majority of the people display optimism (which is generally considered as a winning attitude), but they are surprised by negative events that happen more often than not. They take risks because they see a bright future and are self-confident. They make more mistakes (and win less frequently) than pessimists although being positive can improve their results and their performance. When few of them win, they win big.

At the same time it is hard for pessimists (which are are seen as "losers") to be surprised. They analyze all the various scenarios, especially the negative, and are ready to cope with them. They see the world as it is. They make less mistakes. They tend not to take risks because things could easily turn bad. They have more winners, but have a lower average winning trade. Their results are less volatile. When they are caught by surprise, it is very, very painful.





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2 Comments so far

  1. Andre Wallin on August 2, 2011 8:51 am

    I wonder if it is random how optimistic people stay optimistic people vs. optimistic people who become mildly depressed. I would assume people formulate their outlook based on past events. I like to compare a once famous Swedish hockey player who befriended my father. The hockey player is very optimistic vs. my dad who I think is mildly depressed. The victories in sports made the hockey player very optimistic and feel like he could conquer anything while my dad feels half optimistic and half vulnerable. The hockey player is not a great business person who would rather help needy children while my dad is very savy at business as well as investments and deals etc. A sports star is insulated from the system, he is more of a cloud who doesn’t have financial risk beyond injuring himself. A business person has all kinds of systemic risk and he can go from everything to nothing very quickly. I think a stock market participant is even more vulnerable than a business person, more liquid and faster. I can’t imagine how an optimistic person could possible make money in the market.

  2. Rogue n Josh on August 3, 2011 4:09 pm

    ‘Triumph of the Optimists’


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