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On wishful thinking

It is very easy to fall into the trap of wishful thinking, which can have nasty consequences
June 18, 2019

“In the Spring a young man's fancy lightly turns to thoughts of love,” wrote Lord Tennyson – the point being that the young man did not actually win the object of his affection. This reminds us that poets have long known something that investors and economists have been loath to acknowledge – that this time of year encourages wishful thinking. It is perhaps no accident that one of the traditionally biggest gambling events of the year – the Epsom Derby – takes place in early June.

Such wishful thinking hits stock markets. Equities have traditionally done badly from spring to autumn. Since 1997 the All-Share index has fallen by 1.1 per cent on average from May Day to Halloween, but risen by an average of 5.1 per cent from Halloween to May Day. Ben Jacobsen at Tilburg University and Cherry Zhang of the University of Nottingham have shown that much the same is true for almost all national stock markets since they began trading. This is because lighter nights in the spring cheer us up, thus encouraging wishful thinking which pushes share prices up too far.

Many people hate this view: surely, they think, our attitudes towards equities are not so easily affected by such irrelevant influences.  

In fact, though, we have plenty of other evidence that shows how quick people are to become overly optimistic. Back in 1968 Robert Knox and James Inkster, two psychologists at the University of British Columbia, asked punters at a racetrack about the chances of particular horses winning the next race. They found that people said that these chances were much higher for horses they had just backed than for horses they were about to back. The mere act of placing a bet made people more optimistic about a horse’s prospects.

Another trigger for wishful thinking can be the opinion of our friends and colleagues. Hans Hvide at the University of Aberdeen and Per Ostberg at Zurich University have shown that people who work together tend to own similar stocks, but such shares do worse than others. Peer pressure and groupthink, then, can induce wishful thinking.

Experiments by Guy Mayraz at the University of Oxford have found a similar thing. He randomly divided subjects into two groups: "farmers" who would profit from a rising price, and "bakers" who would profit from a falling one. He then asked them to predict future moves in the price of wheat based on charts of past prices. He found that farmers predicted higher prices than bakers. Simply attaching meaningless labels to people, then, can also cause wishful thinking.

If wishful thinking can emerge so easily it must be widespread and have several economic effects. A recent paper by New York University’s Andrew Caplin and the University of Michigan’s John Leahy describes some of these.

One, they say, is that people spend and borrow too much because they hope to enjoy rising incomes from which they’ll be able to save in future. This leads to higher consumer debt, and to higher interest rates than we’d have if everybody had a wholly sober assessment of their prospects.

Another is that asset price bubbles are more likely, as investors over-rate the chances of high future payoffs.

A third consequence is that investors trade shares too much. Wishful thinkers interpret ambiguous evidence as corroborating their prior beliefs, so bulls see it as a reason to buy and bears as a reason to sell.

In other contexts, though, wishful thinking can actually reduce trading. Homeowners tend to overvalue their own houses, thinking them much more desirable than their neighbours’ similar houses. They therefore demand high prices even in weak markets, which means that transactions dry up and prices are slow to fall.

You might think that wishful thinking also causes companies to invest too much. True, it can. But it can also have the opposite effect. Bosses prone to wishful thinking might think that if they delay investing until the outlook becomes clearer the project will become much more profitable.  The result is that more investment gets postponed.

From the point of view of conventional economics all this is weird. It says that people are rational and so should choose beliefs that best fit the facts, as it is rational actions that will maximise our payoffs.

This view, however, is mistaken. Beliefs are not just a reason for action. They are also sources of happiness or misery in themselves. Naturally, most of us would prefer to believe that which makes us happy. And we often have wiggle room to indulge this preference because evidence is ambiguous or missing. One reason why we get bubbles in new assets – such as tech stocks in the 1990s of cryptocurrencies in 2017 – is that investors don’t have sufficient facts to anchor their expectations which means that wishful thinking can take over.

It's tempting to infer from this that wishful thinking is just another of the countless errors of judgment that can lead us astray.

Not entirely. It can be a good thing. It inspires people to take risks they otherwise would not, and these risks can occasionally pay off hugely for themselves and society. Mark Zuckerberg and Bill Gates, for example, both dropped out of Harvard to set up their own businesses – something that nervous ninnies would not have done.Without wishful thinking, therefore, we would have less innovation and fewer new companies than we otherwise would.

People are not desiccated calculating machines. And that's a good thing, too.