People tend to be either pessimist or optimist by nature. In this article, I look at a study that asked the following question: Optimists vs pessimists – who are the best investors and traders?
The best investors and traders are probably not too pessimistic or optimistic. Both excessive pessimists and optimists are poor investors and traders. As with most things in life, balance is the key.
Moreover, research indicates intelligent people tend to be more pessimistic than “unintelligent” people.
Let’s look at the research:
Optimists Vs Pessimists – Who Are Best Investors And Traders?
I found a research report by Chris Dawson called Looking on the (B)right Side of Life: Cognitive Ability and Miscalibrated Financial Expectations.
I believe the results are highly relevant for both investors and traders. I quote from the abstract:
It is a puzzle why humans tend toward unrealistic optimism, as it can lead to excessively risky behavior and a failure to take precautionary action.
Using data from a large nationally representative U.K. sample (36,312), our claim is that optimism bias is partly a consequence of low cognition—as measured by a broad range of cognitive skills, including memory, verbal fluency, fluid reasoning and numerical reasoning.
We operationalize unrealistic optimism as the difference between a person’s financial expectation and the financial realization that follows, measured annually over a decade. All else being equal, those highest on cognitive ability experience a 22% (53.2%) increase in the probability of realism (pessimism) and a 34.8% reduction in optimism compared with those lowest on cognitive ability. This suggests that the negative consequences of an excessively optimistic mindset may, in part, be a side product of the true driver, low cognitive ability.
The findings are better summarized in this chart that I found in the research paper by Dawson:
Based on the chart above, those with high cognitive abilities tend to be pessimists or realists, but less likely to be optimists.
On the other hand, low cognitive ability tend to be more optimistic.
However, both extreme optimism and pessimism can lead to poor investment and trading decisions.
Unrealistic optimism might lead to recklessness of your finances. If you assume (impossibly) high returns based on your backtests, you may not get the results you expect. You might take on too much risk.
Or, if you believe markets only go up, you’ll be unprepared for inevitable downturns and drawdowns.
On the other hand, the study found that highly intelligent people are more prone to extreme pessimism. This is certainly not an advantage either.
Excessive pessimism, often perma bears, is almost certain to lead to poor results. In fact, many brilliant minds make terrible investors due to their overthinking and tinkering. Overthinking is certainly a problem in short-term trading.
The highly intelligent investor Warren Buffett once said:
If you have more than 120 or 130 IQ points, you can afford to give the rest away. You don’t need extraordinary intelligence to succeed as an investor.
If you are too intelligent, it might mean you have a liability – not an asset!
Which is better in trading – optimist or pessimist? A personal view
Striking a balance is essential in most aspects of life, and trading and investing are no exception.
You need to understand your tendency toward optimism or pessimism and balance it with your emotional temperament.
For example, I tend to be slightly pessimistic (and I’m (sadly) not particularly intelligent). This has cost me a lot of money over the years. I am too conservative in both my short-term trading and long-term investing. I know it, but I have accepted that this is my nature and have adapted my investments.
But being slightly pessimistic has also made me survive many setbacks in trading. I have seen other traders exit after big losses and have never been able to recover.
I have never even been close to having any losses that made me question my path. Being safe and not sorry has paid off for me. My only regret is having too small an allocation to stocks for my long-term portfolio and having too much cash and “safe” investments.
Over my trading career I have found three things that often are very negative:
- Naivety: Some investors and traders lack both knowledge and experience, but still are full of hope and optimism. This frequently leads to disastrous decisions.
- Optimism is based on “after the fact”. You see a backtest with a very successful result but ignore the drawdowns. But in real life, the drawdowns are very painful and we tolerate smaller drawdowns than we imagine, sadly.
- Overconfidence: Highly intelligent investors may become overly confident in their abilities, believing they can easily outsmart markets and other investors. Everyone has “blind spots” and biases we have NOT recognized. Overconfidence can lead to trouble if you lack the self-awareness to recognize your blind spots.
I quote from Juel Anderson’s Poker (Trading), Sex And Dying by Juel Anderson:
I briefly explain all 13 personality traits and ask the participant to choose the one they feel most aptly describes their dominant personality trait. Guess what? Almost 50% will choose a trait that is incorrect. Almost 10% will choose a trait that is at the opposite end of the personality spectrum.
What is obvious to others, is not obvious to ourselves. However, the markets are a brilliant place to learn if you are willing to listen!
Optimist vs pessimist – what does it mean for your money?
Rational optimism stands in stark contrast to blind optimism. While I believe the stock market will rise over time, I recognize that recessions, bear markets, drawdowns, and crashes are inevitable along the way. Stocks typically trend upwards, but they also experience occasional downturns. It is a “fact” – so better be prepared.
Equally important is balancing self-confidence in your abilities with the self-awareness to recognize your shortcomings.
Let’s end the article with some wisdom from a highly intelligent man:
To my knowledge, Einstein proposed five ascending levels of intelligence:
- Genius; and…….