A recent study has uncovered a striking connection between cognitive ability and the tendency to have unrealistic financial expectations. The findings, published in Personality and Social Psychology Bulletin, provide evidence that individuals with higher cognitive abilities tend to have more realistic, or even pessimistic, views about their financial future.
Humans often exhibit unrealistic optimism, particularly in their financial decisions. This optimism bias – the inclination to overestimate positive outcomes while underestimating negative ones – has been extensively documented. Previous studies have shown that people tend to overestimate their future earnings and life expectancy while underestimating the likelihood of negative events like divorce or health issues. The curiosity here lies in understanding why, despite the advantages of unbiased assessments, people still skew towards optimism.
This latest study, spearheaded by Chris Dawson, an associate professor in Business Economics at the University of Bath School of Management, builds on these foundations. Dawson sought to investigate whether this optimism bias, particularly regarding financial expectations, could be linked to cognitive abilities – a factor not thoroughly examined in earlier research.
“I have a longstanding interest in why people are persistently optimistic about the future despite constant feedback from their environment – that is, people should be able to learn about their realistic probabilities for good and bad events,” Dawson told PsyPost. “It seemed to me that in this view cognitive biases, like optimism, could be linked to cognitive abilities.”
The study analyzed data from Understanding Society, a comprehensive annual survey spanning from 2009 to 2021, which included around 36,312 individuals from various households across the United Kingdom. This dataset provided a rare opportunity to observe financial expectations and outcomes over multiple years, offering a rich ground for analysis.
Participants were asked about their financial expectations for the following year – whether they believed they would be better off, worse off, or about the same. These expectations were then compared to the actual changes in their household income, measured and adjusted for inflation and household size. Participants were categorized into groups ranging from “extreme pessimism” to “extreme optimism” based on the comparison between their financial expectations and the actual financial outcomes.
Additionally, the study evaluated cognitive abilities through various tasks assessing memory, verbal fluency, subtraction, fluid reasoning, and numerical reasoning. These measures were used to create a standardized cognitive ability score for each participant.
Dawson found that individuals with higher cognitive abilities were less likely to fall into “extreme optimism” about their financial futures. In contrast, they were more likely to have realistic or even pessimistic expectations. For example, those with cognitive abilities two standard deviations below the mean exhibited a higher probability of “extreme optimism” compared to those two standard deviations above the mean.
Moreover, he found that this relationship held true even after accounting for factors like educational attainment, suggesting that the link between cognitive ability and financial optimism is not merely a reflection of higher education levels.
“Forecasting the future with accuracy is difficult, and for this reason alone, errors in forecasting, both optimistic and pessimistic, may be more likely to arise for those low on cognitive ability,” Dawson said. “However, the results indicate that low cognitive ability leads to an increased probability of just self-flattering biases. This pattern of results is consistent with the idea that humans are naturally primed to be optimistic and that intelligence governs the ease to which this primed response can be overridden when important financial decisions have to be made.”
Dawson suggested that the ability to override intuitive responses might play a role in the relationship between cognitive ability and unrealistic optimism. According to dual-process theories of cognition, our minds operate using two systems: an intuitive, fast-acting System 1 and a more analytical, slower-acting System 2. Individuals with higher cognitive abilities are posited to have a more pronounced capacity to engage System 2, enabling them to critically assess and, if necessary, override the automatic judgments and decisions generated by System 1.
In the context of financial expectations, this means that those with higher cognitive abilities might be less swayed by initial optimistic impulses and more inclined to consider a broader range of information, including potential negative outcomes. This capacity for critical reflection and deliberation allows for more balanced and realistic assessments of future financial situations, reducing the tendency towards unrealistic optimism.
“When we think about the future we may be primed to expect the best, perhaps it helps us stay motivated to do things,” Dawson told PsyPost. “However, when it comes to serious decisions about health, wealth and careers, we need to try an override this tendency towards optimism and think about these decisions realistically. This leads to be better decision making and hence higher well-being for individuals.”
While the findings are compelling, several limitations and future research directions were noted. One concern is the potential influence of omitted variable bias. For instance, individuals with lower cognitive abilities might be in environments that inherently make financial forecasting more difficult, thus influencing their optimism bias. Additionally, the study’s reliance on self-reported data could also introduce some inaccuracies.
Looking ahead, the researchers suggest exploring the mechanisms through which higher cognitive ability leads to more realistic financial expectations. Is it due to a better processing of information, or do individuals with higher cognitive abilities more effectively resist the allure of optimism bias? Answering these questions could provide further insights into the complex relationship between cognitive ability and financial decision-making.
“I speculate as to why optimism bias and cognitive ability are correlated, but we still don’t know the underlying mechanism,” Dawson said. “That is, the mechanism through which unrealistic optimism—perhaps a universal part of our naturally primed heuristic response system—is overridden by intelligence is an open question. It could be that those high on cognitive ability more able to resist the immediate affective benefits of holding a positive outlook about the future and recognize the need for more realistic or cautious expectations, which may lead to present gloom but also to better decision-making.”
“Or perhaps, those high on cognitive ability are more symmetric in how they incorporate (or attribute) undesirable and desirable information, from their past or present, into their current beliefs,” the researcher explained. “This last point stems from the idea that the optimism bias can only be maintained if individuals update their beliefs optimistically when new information is positive but neutrally when new information is negative or, in a similar way, if people attribute past success to their own skill and failure to bad luck. I have PhD students working on uncovering this.”
The study, “Looking on the (B)right Side of Life: Cognitive Ability and Miscalibrated Financial Expectations“, was published online on November 10, 2023.