What is... | November 11, 2016

What is the ostrich effect?

There is an old myth that ostriches tend to bury their heads in the sand when they’re scared, pretending the hazard doesn’t exist if they can’t see it. Do you do the same?

Acting like a 200-pound bird with a two-ounce brain isn't all bad but believing that if you stick your head in the sand for long enough, the problem will take care of itself isn’t really the best financial strategy.

In 2003, Dan Galai and Orly Sade of the Hebrew University of Jerusalem coined the term to describe the way investors stick their heads in the sand during apparent risky financial situations by pretending they do not exist. They found that in an uncertain situation, investors are willing to pay more for an investment where the risk is reported fewer times in comparison to when the risk is reported more frequently i.e. paying a premium for the ‘bliss of ignorance’.

People who are highly anxious about their finances tend to ignore potential money problems while those who are less emotional about finances appear more likely to tackle problems and seek assistance

Ignorance is bliss
This behaviour can partly be explained by the disposition effect, the tendency to minimise the feeling of loss even when it doesn’t make financial sense to do so. Conventional economics says investors should care about their total wealth, not how much they gain or lose from moment to moment. But investors are not robots. They want to maximise pleasure and avoid pain as much as possible. This is often why we see some unwilling to sell an investment that has fallen in value to avoid actually realising the loss. 

Research by behavioural economist George Loewenstein and colleagues has found that investors account login activity reduces after market downturns providing more evidence for the ostrich effect. American Vanguard mutual-fund holders checked their account values far less often in June 2008 than in mid-to-late 2007, when stocks were setting new highs. 

Head in the sand all the time
You can observe ostrich-like behaviour whenever people are emotionally invested in something and have some ability to shield themselves from its negative consequences. This can include everything from checking your credit card balance to avoid seeing how much you’ve spent (or overspent), to sorting out your will or inheritance affairs or even avoid counting your money while betting. The ostrich effect can sometimes be the reason why we let those piles of receipts gather dust until the last day before a tax deadline and also why so many of us are so ill-prepared for retirement. It’s easy to try and avoid the looming reality and miss chances to contribute to our retirement accounts when young. 

Self-imposed stress
Research from the University of Georgia, USA, suggests people who feel anxious about money generally find it harder to make decisions about their finances. “High anxiety levels often lead to a form of self-imposed helplessness,” write authors John Grable, Wookjae Heo and Abed Rabbani. 

In an award-winning experiment, the scientists wired people up to discover how they might really respond to financially stressful situations. They found people who are highly anxious about their finances tend to ignore potential money problems and may be less likely to ask for help or look for a solution. Those who are less emotional about finances appear more likely to tackle problems and seek assistance. 

Other studies suggest the ostrich effect can be increased by habits of thought such as present bias – making it even more tempting to avoid decisions about personal finances for weeks, months or even years. The typical anxiety about maths and dealing with numbers also encourages procrastination. 

Another thing which can aggravate this is cognitive dissonance– the state of holding conflicting ideas, beliefs or values at the same time. Goetzmann and Nadav Peles in a study in the Journal of Financial Research, showed that even well-informed and successful investors tend to irrationally alter their perception of their investments when they don’t do so well. In other words, the investors revised their attitudes in an attempt to reconcile this with their self-image as a “good investor”. 

Turning yourself into the proverbial ostrich may feel like the easy thing to do but ignore financial problems at your own peril – they can simply grow bigger over time.

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eZonomics team
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