Optimism bias in market: What is it and how does it impact your portfolio?

What is the optimism bias?

Optimism bias causes individuals to underestimate the likelihood of negative events occurring in the future, while overestimating the likelihood of positive events.

Humans tend to focus more on what can go right, instead of what can go wrong. And, when we become over-optimistic, we tend to take more uncalculated risks. The bias is further amplified by the ‘illusion of control’.

For e.g., people assign a higher value to lottery tickets they pick themselves, believing these tickets are more likely to win even though the winning probability is the same.

How does optimism bias affect investors?

– Investors with optimism bias believe that the investments they choose are less likely to experience negative outcomes. This leads them to take on more risk than they can handle, potentially resulting in significant losses.

– Investors with optimism bias tend to focus on positive information about their investments while ignoring or downplaying negative news or data. This leads to delayed reactions to negative developments, resulting in losses.

Testing the optimism bias

One way optimism bias manifests is that investors tend to buy low-quality stocks as they appear attractive during favourable market conditions. They tend to assume that the current good price performance is a proxy for earning power and confuse prosperity with safety. We decided to test this bias using real world information.

Based on internal proprietary quality score, companies can be assigned to any of the 4 quartiles with quartile 1 (Q1) being the best.

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What is the quality score you ask?

While the “Quality” factor has its root in fundamental analysis and has been around for some time, issues such as the Enron scandal, revived interest in it. A major drawback of this factor is that there is no consistent definition of what is considered quality.

The Windmill Capital team, after intense research, created the proprietary quality score. We used 4 pieces of financial information to calculate the score:

-Management Effectiveness is determined using Return on Equity (ROE)%

-Financial Strength is evaluated using the Debt/Equity ratio

-Earnings quality is estimated using an accrual ratio ((Net income – Free Operating Cash Flow) / Total Assets)

-Consistency in performance is gauged through earnings variability over the past 5 years.

When calculating quality scores for banks and NBFCs we use capital adequacy ratio instead of gearing ratio. In case of insurance companies, gearing ratio is substituted by insurance leverage ratio.

Based on the quality score, companies can be assigned to any of the 4 quartiles. Companies in quartile 1 (Q1) are the best and so on. The below chart displays the sector wise quartile breakup of quality score.

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Nifty Realty index has outperformed both Nifty IT & Nifty 500 during the recent bull runs.

Seeing the performance only in bull cycles, investors can become overly optimistic about the future prospects & ignore the low-quality score of this sector.

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The IT sector has several high-quality companies with low debt levels and high return on equity.

Hence, it has weathered bear markets better than the realty sector.

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If an investor took a buying decision solely based on positive price performance, rather than intrinsic value, they could lose more in the long term.

That’s why the realty sector, which is dominated by low-quality stocks, has generated lower returns than the market since July 2010.

How to avoid over-optimism

Education – Investors must educate themselves about the risks associated with different types of investments. They must then develop a well-thought-out investment strategy based on their financial goals and risk tolerance.

Be a critic – Always look at the downsides of a new investment. If you only look at the positives, you run the risk of trying to mould reality to fit into your viewpoint.

Seek outside opinions – Consult with trusted experts to get an unbiased perspective on investment decisions.

While optimism bias can have positive effects on mental health and motivation by boosting confidence and resilience, it can also lead to poor decision-making when it comes to assessing and managing risks. Recognising and mitigating optimism bias is important, especially when it comes to investing.

Naveen KR is smallcase Manager and Senior Director at Windmill Capital.

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Updated: 14 Oct 2023, 11:50 AM IST