If there was ever a perfect example of the perils of overoptimistic investing, the GameStop saga would have to be it.

Despite clear evidence that the video game retailer’s stock was becoming grossly overvalued in early 2021, an army of enthusiastic day traders poured more money into it. Many hoped for a quick cash grab. Most didn’t get it.

After rising to a value of nearly US$350 per share in late January, the GameStop stock quickly crashed, taking many hoped-for fortunes with it.      

It may be an extreme tale of what can happen when too much investor optimism clouds decision-making. But as Rotman assistant professor of finance Goutham Gopalakrishna points out, overoptimism — or a fervent belief that returns will keep rising no matter what — is clearly a common force in the economy.    

“We see a lot of excessive optimism out there — from the decisions of some hedge funds to more recently with investments in companies like Nvidia and SMCI,” he says. Yet as common as overoptimism can be, most macroeconomic modelling research ignores it, writes Gopalakrishna in a new working paper.

He and his coauthors, Seung Joo Lee (University of Oxford) and Theofanis Papamichalis (University of Cambridge), wanted to change that. They developed a model that they hope can help regulators and investors understand how optimism might impact personal wealth and the overall state of the economy.     

One of the big takeaways for investors is to be wary of too much optimism. It can not only exacerbate financial instability for the optimists, but it can lead to big losses for the more rational investors too.      

Gopalakrishna and his coauthors started building their model using data from the Survey of Professional Forecasters to conceptualize who optimistic and rational investors are. This survey polls different industry experts in the U.S. about what they think the GDP growth rate will be in the future.  

Gopalakrishna says that optimistic and rational investing is really about an outlook on what you choose to invest in. “Some groups are pretty rational in the sense that if the growth rate of capital has been, say, two per cent, they expect to get two per cent,” he explains. “There are others who might always expect to get three per cent even when the growth rate was historically two per cent — they are always overly optimistic.”  

The researchers modelled what would happen when there was higher versus lower growth in invested capital than expected. Unsurprisingly, when there was a positive shock in the economy and higher growth in the investment, the optimists made more money than the rationalists because their excessive confidence led them to invest more.      

But when there was a downturn in the economy and the investment, that optimism proved disastrous for some. Because optimistic investors expect positive returns, they kept investing despite signs they shouldn’t.

“And what we show in the paper is that once optimism crosses a threshold and they become excessively optimistic, that misjudgement of expected returns — what we call the ‘expectation error’ — dominates and it drains their wealth slowly,” says Gopalakrishna. “In the long run, these people end up losing all of their wealth, and that is what we call the ‘net worth trap.’”

The researchers also show that if there are too many excessive optimists, that net worth trap can be bad for the overall welfare of the economy. The reason is that those optimists are usually the ones driving innovation in the economy. Once their economic might is removed, so is economic growth.      

There are a couple of practical takeaways for investors, says Gopalakrishna.

One is that for individual investors, it’s not enough for you to be rational about expected returns. You also have to think about the expectations of others.

“The whole idea of belief formation in finance has been mostly focused on an individual’s perspective, but here we’re saying you also need to also be aware of the other agents in the asset market and what kind of expectations they’re forming,” says Gopalakrishna.

In other words, he says, it’s crucial that regulators and investors are aware of all investor expectations since optimistic investors can play an oversized role in economic growth, and decline.  

Thus, the second big lesson investors should take from this research is to be aware of who forms the wrong expectations, says Gopalakrishna.

“For example, if there’s a hedge fund with very deep pockets that forms wrong expectations, then that poses a serious risk for a rational investor like me because their mis-specified expectations will drive them out of the market in the long run. That can be disastrous for me – the rational investor - and for the overall economy as well.”