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The Economic Power -- and Pitfalls -- of Optimism

People who are extremely optimistic tend to have short planning horizons and act in ways generally not considered wise.

People who are optimistic are more likely than others to display prudent financial behaviors, according to new research from Duke University's Fuqua School of Business.

But too much optimism can be a problem: people who are extremely optimistic tend to have short planning horizons and act in ways that are generally not considered wise.

Manju Puri and David Robinson, professors of finance at Duke, report in the October 2007 issue of the Journal of Financial Economics that the differences between optimists and extreme optimists provide important insights into the interaction between psychology and economic and lifestyle choices.

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Puri and Robinson developed a novel method to assess individuals' levels of optimism, drawing on data from the Federal Reserve Board's Survey of Consumer Finance (SCF), a triennial assessment of U.S. families' financial and demographic information. Although the SCF does not ask about optimism directly, it does ask respondents how long they expect to live. It also collects demographics, and health-related information--the same sort of information that actuaries use to estimate life expectancy.

The Duke researchers combined these data to determine participants' statistical life expectancies. Then they compared the statistical and self-reported life expectancies and categorized anyone who expected to live longer than the data predicted as an optimist.

"Most of the information we needed was already there, but we had to create a new way of combining it with other existing data in order to extract meaning about optimism," Puri said.

Puri and Robinson also labeled as "extreme optimists" the top 5 percent of optimists, those who think they will live an average of 20 years longer than is statistically likely.

Optimism indeed relates to a large number of behaviors, they found. In small doses optimism can lead to wise decision making, but extreme optimists "display financial habits and behavior that are generally not considered prudent," the authors wrote.

Puri and Robinson find that optimists: • Work longer hours; • Invest in individual stocks; • Save more money; • Are more likely to pay their credit card balances on time; • Believe their income will grow over the next five years; • Plan to retire later (or not at all); • Are more likely to remarry (if divorced).

In comparison, extreme optimists: • Work significantly fewer hours; • Hold a higher proportion of individual stocks in their portfolios, and are more likely to be day traders; • Save less money; • Are less likely to pay off their credit card balances on a regular basis; • Are more likely to smoke.

"The differences between optimists and extreme optimists are remarkable, and suggest that over-optimism, like overconfidence, may in fact lead to behaviors that are unwise," said Puri.

The findings could lead to useful ways to consider individuals' investment and career planning decisions, and help people understand or overcome personality characteristics that can negatively affect important financial decisions, the authors say.

"Doctors tell us that one or two glasses of red wine a day can be really healthy," Robinson said. "But no one tells you to drink the whole bottle. It's the same with optimism. A little bit is really beneficial, but too much can lead to some really bad economic choices." Lau