Guest Post – Should Funds Hire Manic Depressives to Correct for "Optimism Bias"

Optimism bias is a well-established illusion of being over- optimistic about future events. The basic idea is that when people judge their chances of experiencing a good outcome they estimate their odds to be above average. But when they contemplate the probability that something unpleasant will happen to them, they estimate their odds to be lower than those of other people. A great number of academic studies have been done on this subject. Some of the well established cases of optimism bias are as follows:

1. People expect to complete personal projects in less time than it actually takes to complete them
2. Second-year MBA students overestimated the number of job offers they would receive and their starting salary
3. Vacationers anticipate greater enjoyment during upcoming trips than they actually expressed during their trips.
4. Newlyweds almost uniformly expect that their marriages will endure a lifetime despite the large proportion of marriages that end in divorce.
5. Most smokers believe they are less at risk of developing smoking-related diseases than others who smoke.

Optimism bias is also quite common in the Real Estate Markets

In the last 4-5 years, the real estate investment community seems to have been a victim of optimism bias. This is most exemplified in the severe under estimation of time/duration required for construction/operation of project investments. For fund managers who have made investments in major parts of Asia (China, Vietnam, India, Indonesia) in the last 4-5 years, under estimation of timelines is the one area in which they all concede to have erred. The experience has shown how easy it is to fall into the optimism bias trap and start believing that once the finance is secured and the contracts awarded, things just roll on in an automode. Following are some of interesting reasons (these are all true) by which projects have gone significantly delayed:

1. –  The approvals have been delayed because the municipal corporation has switched from a manual system of approvals to an electronic system of approvals and there is a bug in their software. We have submitted the building plans in a CD but their software is unable to read it.-  There is labour shortage because of the Commonwealth games being held in the country. All the labourers from the neighbouring states have been called in for the Commonwealth games and hence work on the site has slowed down.
2. –  Number of labourers have gone down because many labourers have registered themselves under the NREGA scheme (a rural employment scheme implemented by the government) and are unwilling to work
3. –  After we submitted the Building Plans, the parking laws have changed and the new parking regulations are yet to come out; once the new regulations come out, we have to revise our plans and resubmit the application

There is no way a fund manager investing in projects could have foreseen such situations; and such situations sometimes do have an impact on the IRRs. But the harsh reality is that such unique events do happen with regular regularity. Therefore, in every investment, an investor has to incorporate for the unknown event that could have an unknown impact, against his optimism bias!

It is believed that the only section of the population that isn’t susceptible to the optimism bias are people with major depressive disorder. Probably funds should consider hiring some of them.

The Full Article can be read at www.therainbowinvestor.com