Why can't we have a realistic basis for optimism?

In his book, ‘Flourish’, Martin Seligman writes:

‘I am all for realism when there is a knowable reality out there that is not influenced by your expectations. When your expectations influence reality, realism sucks’ (p 236-7).

I have been thinking about the sentiments in that paragraph at various times over the last couple of days. My initial reaction was that it was wise as well as well written. The problem I now have with the passage is that in the context in which it is written it seems to imply that a realistic frame of mind is inconsistent with optimism. It seems to me that if we are realistic about the right things this can provide us with a stronger basis for optimism. (As an aside, the grammar check in Microsoft Word doesn’t agree with me that the passage was well written. It calls the second sentence a fragment and suggests that it be re-written. Robots have a tendency to be pedantic!)

I will give an example to explain why I think a realistic frame of mind can be optimistic and then consider the broad context in which the paragraph was written. A prime example of expectations influencing reality is in relation to our own behaviour e.g. in playing a sport. If you decide to be realistic about how you will respond to a given situation in future you might think that the most likely outcome is that you will perform in much the same way as you have in similar situations in the past. That might make tend to make you pessimistic about your prospects for improvement. Yet, when you think about it more deeply, a realistic frame of mind could enable you to make use of your inside knowledge of your own potential and your intentions in developing your expectations of your future performance. Your inside knowledge might thus provide you with a realistic basis for more optimistic expectations.

The context in which Seligman’s paragraph appears is in a discussion of the influence of expectations on capital markets and individual health outcomes. The evidence that he presents that expectations can influence individual health outcomes seems to me to be fairly strong. It may be worse that useless, however, for well-meaning people to use this knowledge to tell pessimists not to be so pessimistic. In my view if we want to help people we should give them plausible reasons for hope. My view on this are not be worth much, but Marty Seligman certainly doesn’t support happiness police urging people to fake positive emotion.

I can claim some professional knowledge about the effects of expectations on capital markets. Seligman’s comments on this topic were prompted by a claim by Barbara Ehrenreich that positive thinking destroyed the economy. According to her view, motivational gurus and executive coaches espousing positive thinking – using scientific props provided by academics like Martin Seligman – caused the recent global financial crisis and subsequent recession by infecting CEOs with viral optimism about economic prospects. Seligman responds that it is vacuous to suggest that the meltdown was caused by excessive optimism. Optimism causes markets to go up. Pessimism causes them to go down.

Ehrenreich is presumably suggesting that the bubble wouldn’t have burst if we didn’t have a bubble in the first place. Well, economists are still arguing about whether we did have an asset price bubble, and I don’t think many of those who think we had a bubble would lay the blame on positive psychology. In looking for the cause of the crisis we need to look for reasons why normally prudent financial institutions took on extraordinary risks. I don’t think it is necessary to look any further than the policies that central banks had pursued in the past that encouraged major financial institutions to believe that they were too big to be allowed to fail. The financial crisis occurred when the Fed decided to break with that policy and let one of the big gamblers go to the wall.

Seligman goes on to discuss asset pricing and the views of George Soros about reflexive reality. In my view he manages to make those views more comprehendible than Soros does. (My difficulty in understanding Soros was evident in this post.) According to Seligman, reality is reflexive if it ‘is influenced and sometimes even determined by expectations and perceptions’.

Economists have known for a long time that the market price of an asset is determined largely by expectations about future earnings from that asset and associated risks (reflected in discount rates). So, wealth can be considered to be a form of reflexive reality because it depends on expectations. As well as expectations about future earnings, the expectations that influence market prices at any time may include expectations that investors form about the optimism or pessimism of other investors – i.e. whether they are too optimistic or too pessimistic and how long they are likely to remain in that state.

From the perspective of the individual investor, however, the expectations of other investors are part of external reality that can be speculated about on the basis of their market behaviour, even though it isn’t knowable with any certainty. Her views about the expectations of other investors may influence her decisions to buy and sell, but her actions will have a negligible effect on market outcomes (unless she is a major player in the markets). Thus, even though asset values are determined by the combined expectations of investors, it doesn’t make sense for an individual investor to view her own expectations as influencing reality.

It seems to me that in personal investment, as in other aspects of life, it is good to have a realistic basis for optimism about the strategy one adopts. For example, consider the following advice that Warren Buffett offered retail investors. His basic message is optimistic: ‘Stocks are the things to own over time. Productivity will increase and stocks will increase with it’. Then he provides some realistic advice about how to avoid buying and selling at the wrong time and how to avoid paying high fees. This leads to even more realism: ‘Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market’. He ends up combining realism with optimism: ‘If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors’. (Comments by Warren Buffett in Spring 2008, quoted in Alice Schroeder, ‘The Snowball’, 2008, p 825.)

It is good to be optimistic, but even better to have a realistic basis for optimism.

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My preceding post was also about Martin Seligman’s book, ‘Flourish’.