Avoiding the Pitfalls of Overconfidence

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Overconfidence Pitfalls

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Avoiding the Pitfalls of Overconfidence while Benefiting from the Advantages of Confidence

Alex B. Van Zant Don A. Moore

Successful leadership depends on the confidence to rally support, win allies, and deter competitors. However, overconfident leaders have led their companies into disaster. This article identifies the circumstances in which leaders are most prone to overconfidence and its concomitant risks. On the flip side, it explores those circumstances under which confidence is most conducive to success. Using insights from recent research, the article provides recommendations on how managers can avoid the pitfalls of overconfidence while benefiting from the advantages of confidence. (Keywords: Decision making, Entrepreneurship, Investments, Leadership, Organizational behavior, Securities trading, Startups)

eading up to its 2008 economic collapse, Icelands small economy, once dominated by rugged fisherman, came to be run by confident young investment bankers armed with degrees from American business schools. Taking lessons from the American banking industry, they borrowed money to purchase foreign companies they had no idea how to manage. Soon, Icelandic bankers were trading assets with each other and inflating their value in the process, creating the illusion that Icelandic banks were profiting. However, as Michael Lewis explains in his best-selling book Boomerang, many believed that their apparent success revealed something profound:Icelandersor at any rate Icelandic menhad their own explanations for why, when they leapt into global finance, they broke world records: the natural superiority of Icelanders. Because they were small and isolated, it had taken 1,100 years for themand the worldto understand and exploit their natural gifts, but now that the world was flat and money flowed freely, unfair disadvantages had vanished.1

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The authors would like to thank Linda Dong and Joe Mazzella for their help in finding examples of overconfidence. The first author would also like to thank California Management Review for financial support during his second year of graduate school.

CALIFORNIA MANAGEMENT REVIEW

VOL. 55, NO. 2

WINTER 2013

CMR.BERKELEY.EDU

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Avoiding the Pitfalls of Overconfidence while Benefiting from the Advantages of Confidence

Icelandic bankers believed they were successful due to their natural superiority. Their belief proved self-fulfilling for a time. However, when foreigners who had invested in Icelandic banks started Don A. Moore is an Associate Professor in to doubt the Icelandic miracle and tried to cash out, the Management of Organizations group the value of these banks fell precipitously. Within a as well as a Barbara and Gerson Bakar short time, the major Icelandic banks failed and Faculty Fellow at the Haas School of Business, UC Berkeley. took the small countrys economy down with them. The overconfidence of bankers had blinded them to their own limitations and the size of the risks they had taken.Alex B. Van Zant is a Ph.D. student in the Management of Organizations group at the Haas School of Business, UC Berkeley.

It is easy to think of other business lessons that parallel the Icelandic parable. Whether America Onlines 2000 acquisition of Time Warner, the housing boom of the 2000s, or the inflation of the dot-com bubble in the late 1990s, overconfidence has accompanied many of the most dramatic business follies. Analysts, journalists, and academics correctly highlight the role of overconfidence in helping set the stage for many calamities. Some have even argued that no problem in judgment and decision making is more prevalent and more potentially catastrophic than overconfidence.2 Indeed, the effects of overconfidence are routinely evident in many different forms. Overconfident plaintiffs and defendants overestimate the chances of a favorable court judgment and resist settling early.3 Their overconfident attorneys perpetuate the conflict by encouraging these beliefs. Likewise, overconfident investors trade assets too much, sure that they have the distinctive insight that allows them to predict the next big investment opportunity.4 Indeed, scholars have gone so far as to claim that overconfidence is perhaps the most robust finding in the psychology of judgment.5 In this article, we discuss the causes and consequences of overconfidence as identified by research, much of which was conducted in experimental laboratories. However, in an effort to illustrate the impact of overconfidence beyond the laboratory, we have identified many examples from the business world where overconfidence was important. A problem with such examples is that, as with the Icelandic bankers story, we identify overconfidence after we have observed results that reveal an initial judgment was overconfident. Selecting instances in which actors appear overconfident runs the risk of inferring overconfidence when bad luck is more to blame. The most persuasive way to address this concern is by studying overconfidence in the research laboratory where we can make stronger conclusions about causation. We base our arguments here on research and employ examples from outside the lab for the purposes of illustrating phenomena that have been demonstrated in empirical research. By using both, we show that the evidence has practical implications for managers. We begin by highlighting the adverse consequences of overconfidence for investors, managers, and entrepreneurs. However, overconfidence is far from universal, and we identify the situations in which it is most likely to be a problem.6 We then consider the other side of the overconfidence coin and discuss some advantages of displaying confidence. The display of confidence is useful for leaders who wish to gain stature, credibility, and influence. Finally, we will provide recommendations

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UNIVERSITY OF CALIFORNIA, BERKELEY

VOL. 55, NO. 2

WINTER 2013 CMR.BERKELEY.EDU

Avoiding the Pitfalls of Overconfidence while Benefiting from the Advantages of Confidence

for how to best avoid the pitfalls of overconfidence while taking advantage of the benefits to expressing confidence. Whether the goal is to simply improve ones decisions or to enhance the effectiveness of ones organization, these recommendations are simple to implement yet effective. However, we must first be clear about what we mean by overconfidence. Overconfidence has basically been studied in three ways.7 The first is overestimation: thinking that youre better than you actually are. The second is overplacement: thinking that youre better than others when youre not. The third is overprecision: being too sure you know the truth. The first two are obviously related, and on any given task they are often correlatedbut they are not the same. To understand the difference, it is worth considering how different forms of overconfidence relate to individuals willingness to engage in competition.

What Drives Market Entry Decisions?In a recent study, Cain, Moore, and Haran tested what kind of overconfidence has the greatest effect on competitive entry decisions.8 Participants in their study completed two tests of skill: an easy quiz and a difficult quiz. After taking both quizzes, each participant was informed that he or she was one of forty contestants competing for prizes that would be awarded on the basis of a raffle in which tickets were earned according to relative performance (i.e., the top person ranked out of 40 would receive 40 tickets while the bottom ranked person would receive only 1 ticket). Participants were given a choice to enter one of two contests: one that used their score on the easy quiz to determine ticket allocation and another that used their score on the difficult quiz to determine ticket allocation. For each participant, one contest had a prize of $45 while the other had a prize of $90. The researchers varied whether the big prize went with the easy quiz and the little prize went with the difficult quiz, or vice versa. Once participants had indicated which contest they would like to enter, they estimated their performance on each quiz and then estimated how others would perform. The results revealed that the easy quiz prompted excess entry whereas the difficult quiz produced insufficient entry. This was driven by the fact that the average participant tended to believe that he or she was better than others on the easy quiz but worse than others on the difficult quiz. Of course, this logic is wrong because people are, on average, average. Because the easy quiz was so popular, the average participant who entered earned only half as much as those who chose the difficult quiz. In fact, entering the easy quiz raffle earned participants less money even when the easy quiz came with a $90 prize and the difficult quiz only came with a $45 prize. Interestingly, participants who entered the easy raffle did not overestimate their performance on the easy quiz any more than participants who entered the difficult raffle. This evidence is strongly suggestive that when people make decisions to enter competitive markets, their decisions are guided more by overplacement than by overestimation. Given the relevance of overplacement in business contests, this article focuses on overplacement rather than overestimation or overprecision.

CALIFORNIA MANAGEMENT REVIEW

VOL. 55, NO. 2

WINTER 2013

CMR.BERKELEY.EDU

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Avoiding the Pitfalls of Overconfidence while Benefiting from the Advantages of Confidence

TABLE 1. Expected Participant Earnings by Raffle Prize Condition and Market EntryEasy Quiz Raffle Entry$45 Easy, $90 Difficult $90 Easy, $45 Difficult Mean expected earnings $1.76 $3.21 $2.52

Difficult Quiz Raffle Entry$6.21 $3.75 $5.09

Note: Results as reported in Experiment 1 of Cain et al. (2012)

Adverse Consequences of Overplacement in Market SettingsThough the study discussed above examines entry into a simple laboratory contest as opposed to a more complex business market, the decision to enter a market for an uncertain prize involves many of the same decision processes as entering any other kind of competitive market. Potential entrants must assess their own capabilities and compare themselves to the competition. Then, they must assess their own risk tolerance, as chance factors may lead to unfavorable outcomes even for the most capable competitors. At the most fundamental level, entering any kind of market is no different from claiming your share of raffle tickets and hoping that fortune favors your success. When people overplace themselves or their organizations relative to the competition, they are prone to inflating their chances of success.

Investment DecisionsOverconfidence leads people to make mistakes in allocating their investments. Although index funds allow people to diversify their risk, avoid transaction fees, and save their own valuable time, they often decide to manage their portfolios more actively by regularly trading assets. Presumably, those who are ready to invest their own time and money into maintaining an actively managed portfolio must have faith in their ability to outsmart the market. If they were accurate in their perception that they could beat the market, then one would expect these investors who actively manage their portfolios to outperform the market. However, Terrance Odean concluded that many investors trade too much.9 They spend their time and energy searching for investments that, on average, underperform the market. In a related study, Barber and Odean reported that from 1991 to 1996, the average household turned over 75% percent of its portfolio annually and earned 1.5% lower annual returns than the market index. The top 20% of households in terms of turnover earned annual returns that were 7.1% lower than households in the bottom 20% in terms of turnover. In the words of the authors, trading is hazardous to your wealth.10 Or in other words, overplacing your ability to forecast stocks is hazardous to your wealth.

Corporate MergersOverconfident individuals make decisions that not only are detrimental to their personal finances, but to the finances of their organizations. When the key decision makers in a firm overplace their abilities relative to those of the management teams of other firms, they become more likely to believe they could better manage

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UNIVERSITY OF CALIFORNIA, BERKELEY

VOL. 55, NO. 2

WINTER 2013 CMR.BERKELEY.EDU

Avoiding the Pitfalls of Overconfidence while Benefiting from the Advantages of Confidence

the other firms. Indeed, Malmendier and Tate found that overconfident CEOs were more likely to engage in mergers.11 After ruling out alternative explanations for their findings, the authors concluded that CEOs who are overconfident in their ability to beat out the competition and earn future returns for their companies are more likely to engage in mergers than well-calibrated CEOs. As the result of engaging in too many mergers, these overconfident CEOs lose value for the shareholders of their firms, including themselves. Every company ought to be worried about the potential for overconfidence among managers at the top. After all, the way people get to the top is by having a career in which they both perform well and are favored by fortune. Top managers often express great faith in the quality of their own intuitive judgment, and indeed they have a careers worth of success to support that faith. However, while their skill may endure, the good fortune that helped put them at the top will not.

The Introduction of New ProductsOverconfident CEOs not only put their companies at risk by undertaking value-destroying mergers, but they also have a tendency to encourage their firms to introduce risky products with a high risk of failure. In a study of small computer companies that were on the verge of launching new products, Simon and Houghton interviewed CEOs and high-level executives about the potential for their new products to succeed. Those who made statements expressing extreme certainty (i.e., definitely or completely sure) were the most likely to have introduced risky products.12 Google is one example of a company that fails often at the introduction of new products. With such ventures as Google Wave, Google Video, Google Checkout, and Google Answers that failed despite extensive investments and publicity, Google has had its share of failures. One way of looking at Googles failure rate is that it is the product of an experimenting corporate culture that preaches a willingness to take risks in order to identify the opportunities that have the most potential.13 Might it also be an expression of overconfidence? After all, Google is run by executives who earn $1 annual salaries with compensation packages that are completely dependent on corporate performance.14 Though one could argue that these executives accept such low salaries out of genuine altruism, as part of a pu...