Monday, November 23, 2009

Overconfidence and Reference Group Neglect

While overconfidence is a complicated phenomenon, it does seem clear that in contests of skill (such as entrepreneurship), we tend to be overly optimistic:

"The large majority of subjects in the self-selection sessions seem to be saying, 'I expect the average entrant to lose money, but not me!'... When subjects’ post-entry payoffs are based on their own abilities, individuals tend to overestimate their chances of relative success and enter more frequently (compared to a condition in which payoffs do not depend on skill). The more surprising finding is that overconfidence is even stronger when subjects self-select into the experimental sessions, knowing their success will depend partly on their skill (and that others have self-selected too). In these sessions, there is so much entry that the average subject loses money in 34 out of 48 periods, and earns money in only four periods. This result suggests a new phenomenon specific to competition, 'reference group neglect'- the tendency to underadjust to changes in the reference group one competes with." -Overconfidence and Excess Entry
Overconfidence can have some advantages; for example, confident people can seem more competent to observers (occasionally to absurd degrees). On the balance, though, overconfidence may be harmful to entrepreneurs:
"...the average survival chances of nascent entrepreneurs are actually lower in countries that exhibit high prevalence rates of entrepreneurial self-confidence." -"I think I can, I think I can": Overconfidence and entrepreneurial behavior
"...both overconfidence and under-confidence have a negative effect on sales growth." -What Makes a Successful Entrepreneur? Evidence from Brazil
"...optimism is on average bad for performance... (however) optimism is much less harmful to performance when loans have a shorter maturity." -Financial Contracting with Optimistic Entrepreneurs
The point about loans is interesting: it appears that being under short-term debt "keeps optimists honest," to coin a phrase, and helps mitigate the negative effects of overconfidence about long-term growth prospects.

Further reading: