Optimism and flawed decision making

Behavioural finance is no longer a “new idea”. It has entered mainstream finance education through CFA, Business Schools, even actuarial exams (ST5 for UK and South African actuaries). Some of the biggest lessons revolve around how bad we as a species are at making decisions in the face of uncertainty. Emotional biases, overconfidence, loss aversion, anchoring, problems related to framing, cognitive dissonance…  In this case it is no exageration to say that the list continues.

These problems are not only related to the financial markets. Hofstadter’s Law is that everything always takes longer than you expected.

Yes, even when taking into account Hofstadter’s Law.

When it comes to public works, Michael Coulson calls it “delusional optimism” in a fascinating short article focussed on our Gautrain debacle and analogous examples elsewhere in the world. The cause of these problems in public works programmes adds another element missing from most individual trading decisions. “Group Think” where a group performs poorly as a result of natural human characteristics in an unfortunate configuration. Given that the financial consequeces of failed, over-budget and under-expectation projects doesn’t fall too heavily on the planners and political sponsors, the third element must be lack of accountability. An awful mix.

Research by Flyvberg, a professor at Aalborg University, concluded:

The average cost overrun on transport schemes, estimates Flyvbjerg, stretches from 20% for road projects to 40% for rail schemes.

Given all the available reasons, perhaps we should consider ourselves  fortunate that the numbers aren’t a great deal worse than that.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.