Pessimism bias

Pessimism bias is the tendency to see the future as worse than present conditions warrant. During bear markets, investors believe the decline will continue. When valuations are low and opportunities abound, pessimism prevents buying. Some investors assume their investments will fail and avoid equity allocation altogether. This systematic pessimism leads to overly conservative portfolios and significant lost wealth.

The mechanism

Pessimism bias arises from:

Loss aversion. Losses feel twice as painful as equivalent gains feel good. This asymmetry can push your forecast of the future toward the pessimistic to protect against downside.

Availability and recency. Recent bad news or a recent crash makes negative outcomes vivid and available. Your forecast is biased toward those bad outcomes.

Personal attribution (reversed). Bad outcomes are attributed to the world (economic recession, market crash). Good outcomes are attributed to luck or external factors. Over time, this asymmetric attribution creates pessimistic forecasts.

Pessimism bias in investing

Bear market psychology. After a crash, pessimism bias is strongest. Investors believe the market will continue to fall, so they stay in cash. But historically, the biggest gains occur in the year or two after crashes, when pessimism is highest. The pessimistic investor misses the rebound.

Avoidance of equities. Some investors become pessimistic on stocks entirely, based on bad experiences (witnessing crashes, hearing horror stories). They hold excessive cash or bonds, foregoing the long-term returns of equities. Over a 40-year career, this pessimism costs millions in forgone wealth.

Underallocation to growth. Conservative investors often hold 30% stocks and 70% bonds, based on pessimistic forecasts of stock returns. If historical returns continue, the bond-heavy portfolio will significantly underperform a more balanced one.

Pessimism on specific companies. An investor reads a negative article about a company and becomes pessimistic on it, avoiding the stock even if valuations are attractive. The pessimistic bias prevents her from seeing the opportunity.

Pessimism bias and fear

Pessimism bias is closely linked to fear. FUD (fear, uncertainty, doubt) drives pessimism. After a crisis, fear is high, pessimism bias is strong, and investors miss the subsequent recovery.

Pessimism bias vs. realistic caution

Pessimism bias is not the same as realistic caution. Some pessimism is warranted: markets crash, companies fail, economies recede. The distinction is in the magnitude:

Realistic caution: “Markets are risky; a 40% crash could occur. I will hold 50% bonds and 50% stocks to manage this risk.”

Pessimism bias: “Markets always crash; I expect returns of -2% annually. I will hold 95% bonds and 5% stocks.”

The first is reasonable. The second is bias-driven and costly.

Pessimism bias and confirmation bias

Once you become pessimistic on an investment, confirmation bias reinforces it. You seek bad news and find it. The pessimism becomes locked in place.

Defenses against pessimism bias

• Calculate the base rate. What is the historical return of stocks over 20-year periods? (9-10% annually.) Does your pessimistic forecast match history? If not, your bias is showing.
• Remember that crashes end. Every crash in history has been followed by a recovery. The pessimistic forecast of continued decline has always been wrong.
• Use a disciplined asset allocation. Rather than allowing pessimism to determine your allocation, set it based on your time horizon and goals. Stick to it.
• Rebalance into weakness. When pessimism is high and markets are down, force yourself to rebalance by buying stocks. This mechanical rule overrides pessimism bias.
• Track pessimistic forecasts. Identify pessimistic investor commentary you have read. Track the investments recommended and their actual performance. Pessimistic forecasters often underperform.
• Remember: the worst time to avoid stocks is when pessimism is highest. When everyone is pessimistic, valuations are low and expected returns are high. The pessimistic investor misses this opportunity.

See also