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Optimism and the credit crunch

Research within Positive Psychology shows that having a positive outlook on life results in both health and well-being benefits: optimism is a good thing. However, wearing rosy tinted spectacles can have a downside and it seems that too much optimism is not a good thing. For example, there are suggestions that the recent economic crisis is down to over optimism among traders and investors. In fact some say that this whole mess is a result of people being unrealistically optimistic and overconfident.

Contrary to what traditional economists say, people do not make rational decisions often they are biased by variables such as optimism or memory.  For example, studies show that in general people consistently think that bad things are less likely to happen to them and more likely to happen to others: and that they will experience more positive events than others too.  Though optimism can be beneficial, according to Professor of finance Hersh Shefrin this optimistic bias can play havoc when translated into the housing market.  For example, many people have been living beyond their means as well as being overly confident about an ever rising housing market and a bright economic future.  People overestimate the positive future and so make decisions based on this bias.

Not only this but studies show that traders falsely attribute changes and fluctuations in the stock market as a result of their own skill and ability, rather than being down to changes in the market.  When things go bad they start to overreact  because people pay attention to recent information  ( last few days/weeks)  rather than long term information ( 5 or ten years) about the market, they make decisions which then have a knock on effect.

Shefrin says that the turbulent times are down to common psychological factors, biases and cognitive errors.  Encouraging people to be more optimistic in such a climate may not be a good thing. To read the article click here

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