An Empirical Analysis of Financial Optimism and Portfolio Choice

Balasuriya, J.W. (2012). An Empirical Analysis of Financial Optimism and Portfolio Choice. (Unpublished Doctoral thesis, City University London)

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Abstract

The purpose of this thesis is to conduct a detailed study of optimism in financial decision making. I contribute to the literature by clarifying the relationship between financial optimism and individual investors’ portfolio choice. I also investigate whether optimism benefits an investor’s objective and subjective well-being within the same study by using large-scale survey data. I then explore how feedback, framing, and personality, contribute to financial optimism using controlled user experiments. Both survey-based and experimental approaches are applied in this thesis to study various aspects of optimism in a financial decision making domain. In this thesis I propose a theoretical framing work for measuring financial optimism and use these measures to analyse investor profiles. My survey-based studies show that optimistic investors prefer to invest in risky portfolios to risk-free portfolios, and borrow higher debt and larger mortgages. Optimists are significantly younger with lower accumulated financial wealth compared to non-optimists. Financial optimism is found to be beneficial in improving objective well-being by increasing future financial wealth, but this positive effect is very limited in terms of increasing future total wealth. Optimism is associated with current happiness and satisfaction which means optimism might help to improve current subjective well-being, but the long-term effect of optimism on happiness might be less desirable if the investor’s realised financial situation is lower than expected. By conducting experiments on subjects given investment tasks in a controlled environment, I find that positive feedback on previous portfolio returns decreases optimism when forecasts on future portfolio returns are made in absolute values, while positive feedback increases optimism when participants forecast in relative terms. I also show that framing influences financial optimism - optimism is higher when forecasting in absolute values than in percentages. I discovered that certain personality traits, such as extraversion and modesty, correlate with financial optimism. Optimism is also strongly positively associated with an attitude for risk tolerance. The overall implications of this thesis is that when making a financial decision, individual investors should not neglect the effect of optimism on their choice of portfolio. Optimism is beneficial towards both objective and subjective well-being, however such positive influence of optimism is fairly limited and should not be magnified. Optimism might not be subject to the control of an individual because optimism could derive from environmental factors, such as feedback and framing, as well as from internal factors to the investor, such as personality and innate risk attitude.

Item Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School
URI: http://openaccess.city.ac.uk/id/eprint/11870

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