Optimism and Portfolio Choice

Abstract

This study develops innovative measures of financial optimism by defining optimism as the overestimation of the favourable outcome in an individual’s future financial situation. The paper finds that optimism has a positive influence on an individual’s preference for risky portfolios and a negative impact on her preference for risk-free portfolios when controlled on other demographical and wealth variables. Optimistic individuals borrow more unsecured debt and take on larger mortgages than non-optimistic individuals indicating that optimistic individuals have a higher risk preference for their portfolios. We use more than 660,000 observations from the British Household Panel Survey covering the period 1991 to 2007 in our analysis. We also find that optimists have significantly different demographic characteristics compared to pessimists or neutral respondents. Optimists are significantly younger, more likely to be male, have higher business ownership, borrow more personal debt and take on a larger mortgage than pessimists. They also have lower accumulated financial wealth and home ownership but have a higher average unemployment rate than people who are pessimistic or neutral towards their financial situation. We were able to obtain these findings across individuals in the BHPS with a statistically significant level of confidence. We verified the robustness of the effect of financial optimism by using alternative measures of optimism, repeating the regression analysis only with the individuals who are the head of households as indicated in the BHPS, and using different years of the BHPS between 1995 and 2005. The results from the robustness test support our main findings.