Looking on the (B)right Side of Life: Cognitive Ability and Miscalibrated Financial Expectations

Abstract

It is a puzzle why humans tend toward unrealistic optimism, as it can lead to excessively risky behavior and a failure to take precautionary action. Using data from a large nationally representative U.K. sample (Formula presented.) our claim is that optimism bias is partly a consequence of low cognition—as measured by a broad range of cognitive skills, including memory, verbal fluency, fluid reasoning and numerical reasoning. We operationalize unrealistic optimism as the difference between a person’s financial expectation and the financial realization that follows, measured annually over a decade. All else being equal, those highest on cognitive ability experience a 22% (53.2%) increase in the probability of realism (pessimism) and a 34.8% reduction in optimism compared with those lowest on cognitive ability. This suggests that the negative consequences of an excessively optimistic mindset may, in part, be a side product of the true driver, low cognitive ability.