Why It (Literally) Pays to Be a Rational Optimist
And yes, there is such a thing as being "too optimistic"
Here’s a quote you’ve likely heard a thousand times…
“Whether you think you can, or you think you can't; you're right “
-Henry Ford
Typically, these types of self-help platitudes give me major eye roll syndrome. It’s the type of advice that sounds nice but feels hollow.
However, dismissing this type of simple advice on sight is not a good strategy either. The easy interpretation of this quote from Henry Ford is a message about embracing optimism and rejecting pessimism.
When it comes to success with money and your career, does it pay to be an optimist?
Yes, but only if you are a rational optimist.
This is the first of a two-part post on the impact of optimism on your finances. In this post, I review:
How optimism impacts your retirement, career, and investment decisions.
The difference between rational and irrational optimists.
Next week, I will review research and exercises you can use to rewire your brain to become more optimistic.
What does it mean to be a financial optimist?
Before we continue, we need to establish a shared understanding of what the term optimism means.
There are a lot of different definitions out there, but the simplest definition of optimism is having generally positive expectations about future events.
Keep that simple definition in mind as we discuss how optimism impacts your financial life.
A 2007 paper by Manju Puri and David Robinson answered the question of whether optimists are better with money than pessimists.1
One of the issues with researching this type of research is that you need a very clear definition of a fairly subjective term.
How did Puri and Robinson define optimism?
Simple.
They asked people how long they expected to live.
They compared their answer to the average life expectancy of someone of their age, ethnicity, current health status, and lifestyle.
An optimist is someone who expects to live longer than their actual life expectancy. That’s about as positive as one can be about future events.
The next problem in the context of financial research is whether this definition applies to financial situations.
They found that those who met their definition of optimism were more likely to have positive future expectations about the economy and that their income is likely to grow over the next five years—even when controlling for past income growth.
So, those who are optimistic about their life expectancy are also optimistic about the economy and their place in it.
How optimism impacts your financial behavior
Puri and Robinson tested how optimism impacts three major financial life decisions.
Retirement planning
Career choices
Investing
How optimists think about their career and retirement
This quote from the paper is a concise explanation of the high-level results.
“We find that more optimistic people work longer hours, anticipate longer age-adjusted work careers, and are more likely to think that they will never retire. This holds even after controlling for demographics, health quality, and whether the respondent is self-employed.”
Let’s dive into the details.
One of the seemingly unintuitive results is that optimists work more hours today and are more likely to continue working long hours into their retirement years.
At first, this seems to fly in the face of conventional wisdom where many people might assume optimistic people would strive for “early retirement” rather than thinking they will “never retire”.
To explain why optimists work so much for so long, allow me to put my economist hat on. Puri and Robinson hypothesize that optimists overestimate their “marginal product of labor”.
Translation: Optimists overestimate the benefits of working more.
They might say something like, “If I just put in the extra hours, I’ll be sure to get that promotion”. Except, sometimes, that additional work is not as productive as they believe it is, and they don’t get the promotion.
So, that explains why they are more likely to work more hours today, but why would an optimist believe they would continue working forever?
Probably for the same reason they work so much today.
This is likely influenced by the optimist’s overestimation of the benefits of their hard work and that their productivity will continue into the future. They also likely believe that the economy in the future and their health will allow them to continue working “forever”.
All of which may—or may not— be true.
This does not mean optimists don’t have successful careers—they do. It simply means optimists tend to work really freaking hard. This makes sense if you consider the pessimist. Why would you bother working hard on your career if you did not believe you were going to be successful? What would be the point?
Today’s newsletter is brought to you by— My book, The Financial Freedom Equation
If you enjoy my articles about money management & side hustles—which, if you are reading this, we can safely assume you do, then you will love my book “The Financial Freedom Equation.”
This book is your blueprint to managing money while pursuing a side hustle in hopes of turning that side hustle into your full-time business.
If that sounds appealing to you, pick up your copy today!
If you have read The Financial Freedom Equation and enjoyed it, could you please click here and leave it a review?
How optimists think about saving and investing
Here’s another quote from the paper.
“We find that optimism is also related to portfolio choice and savings decisions. Optimists save more. They are more likely to own individual stocks, and they tend to own a larger fraction of their equity wealth in individual stocks. Thus, they appear to be stock-pickers However, there is no evidence that more optimistic people tilt their portfolios more toward equity per se.”
To borrow a podcasting term, “there’s a lot to unpack here”.
The very unsurprising result is that optimists save and invest more money than pessimists. If someone has hope for the future, they will save money for that future. If they don’t, then they won’t.
The fact that optimists are more likely to be stock pickers is not surprising and makes me wonder about the connection between optimism and overconfidence—Spoiler: we will discuss that connection next.
What is surprising is that there was no evidence that optimists allocate more of their portfolios to risky assets like stocks compared to safer assets like bonds.
Optimists appear to be prudent in their asset allocation but tend to make the irrational choice of thinking they can pick stocks to outperform the market.