Optimism bias in investing: why expected returns are usually too high

Surveys of individual investors typically find expected annual returns of 10–15% in real terms, with expectations rising further during bull markets. Long-run historical equity returns are about half that figure, and risk-adjusted real returns even lower. The persistent gap between expected and realised returns is optimism bias at work.

What optimism bias is

Optimism bias is a documented cognitive tendency to overestimate the probability of favourable outcomes and underestimate the probability of unfavourable ones. The bias has been documented across many domains—health, professional achievement, marriage, longevity—and is one of the most robust findings in cognitive psychology. Investors are no exception: across decades of survey data, the typical individual investor systematically expects higher returns and shallower drawdowns than the historical record actually delivers.

Optimism bias is distinct from overconfidence. Overconfidence is excessive confidence in the precision of one's beliefs—an investor convinced they know exactly what a stock is worth, even when they do not. Optimism is excessive belief in favourable outcomes regardless of the precision of the underlying belief: an investor who freely admits they do not know what will happen but still expects things to turn out well. The two often coexist but operate through different channels.

Weinstein (1980) is the canonical source on optimism bias generally; Shefrin (2000) and others have documented the investing-specific manifestations.

How it manifests in investing

The most direct manifestation is excessive return expectations. Surveys of individual investor expectations consistently find expected annual returns of 10–15% in real terms—approximately double the long-run historical average for diversified equities, and far above what bonds, cash, or any non-equity asset has ever delivered over multi-decade windows. The gap is largest during bull markets and shrinks during drawdowns, which is itself an indicator: the bias is influenced by recent experience, not anchored to any structural estimate.

A related manifestation is over-aggressive savings and spending plans. An investor who expects 12% returns will calculate that a much smaller amount of saving is needed to reach a given retirement target than would be required at 6% returns. The optimistic projection produces under-saving, and the gap between optimistic plan and realised outcome accumulates compoundingly over a working career.

A third manifestation is selective attention to favourable outcomes. Investors who follow their portfolios closely tend to remember the winning trades vividly and the losing trades vaguely. The mental account of one's investing record skews toward the successes, which reinforces optimism in subsequent decisions—a feedback loop that can persist for years before a major drawdown forces recalibration.

The cost

The cost of optimism bias is most concretely measurable in retirement planning. The 4% safe withdrawal rule (Bengen, 1994) is calibrated for long-run real returns of approximately 5% on equities and 2% on bonds—figures that reflect the historical average net of inflation. An investor who plans on the basis of a 7% real return and finds themselves earning the historical average will draw down the portfolio at a rate the realised returns cannot sustain. The shortfall typically becomes visible only when the planning error is too large to correct, in the late stages of retirement.

The cost during the accumulation phase is the cumulative under-saving driven by optimistic projections. An investor saving 8% of income on the assumption of 10% real returns will reach a smaller terminal balance than one saving 12% on the assumption of 5% returns, even if the realised return for both is 6%. The first investor's optimism leaves them with materially less capital at retirement, and the consequences are not reversible by adjusting expectations late in the process.

Optimism bias also drives the decisions that turn moderate drawdowns into severe ones. An investor who entered a position with optimistic expectations is slower to recognise that the position has fundamentally deteriorated, and is more likely to add capital on weakness rather than re-evaluate the original thesis. The bias compounds within individual positions just as it compounds across the portfolio.

What helps

The structural remedy is calibration against the historical record rather than against intuition. The long-run real return on global equities is approximately 5–6%; the long-run real return on government bonds is approximately 1–2%. Any forward-looking assumption that materially exceeds these figures requires a specific, defensible reason—a structural shift in the cost of equity capital, a known change in the tax regime, an explicit factor tilt with documented persistence. Without such a reason, the historical record is the better starting estimate.

The systematic, rules-based investing case applies here in a specific form: by anchoring decisions to documented historical statistics rather than to the investor's optimistic intuition, a rules-based framework removes the channel through which optimism becomes a portfolio decision. Performance reporting that includes explicit drawdown statistics, time underwater, and historical worst-case episodes provides a counterweight to the natural tendency to remember favourable periods more vividly than unfavourable ones.

Optimism bias in pfolio

pfolio's analytics report historical performance and risk metrics—drawdown, volatility, Sharpe ratio, and the rest—for any asset or portfolio. These statistics provide a frame of reference against which subjective return expectations can be calibrated, replacing intuition with the actual return distribution the asset has historically delivered.

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