From Daniel Kahneman “Thinking, Fast and Slow”
Is Overconfidence Good or Bad?
- “Psychologists have confirmed that most people genuinely believe that they are superior to most others on most desirable traits—they are willing to bet small amounts of money on these beliefs in the laboratory. In the market, of course, beliefs in one’s superiority have significant consequences. Leaders of large businesses sometimes make huge bets in expensive mergers and acquisitions, acting on the mistaken belief that they can manage the assets of another company better than its current owners do. The stock market commonly responds by downgrading the value of the acquiring firm, because experience has shown that efforts to integrate large firms fail more often than they succeed.” (p. 258)
- “Organizations that take the word of overconfident experts can expect costly consequences. The study of CFOs showed that those who were most confident and optimistic about the S&P index were also overconfident and optimistic about the prospects of their own firm, which went on to take more risk than others.” (p. 262)
- “(Executives) make decisions based on delusional optimism rather than on a rational weighting of gains, losses, and probabilities. They overestimate benefits and underestimate costs. They spin scenarios of success while overlooking the potential for mistakes and miscalculations. As a result, they pursue initiatives that are unlikely to come in on budget or on time or to deliver the expected returns—or even to be completed.” (p. 252)
- “those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically overconfident.” (p.219)
- “The main point of this chapter is not that people who attempt to predict the future make many errors; that goes without saying. The first lesson is that errors of prediction are inevitable because the world is unpredictable. The second is that high subjective confidence is not to be trusted as an indicator of accuracy (low confidence could be more informative).” (p. 220)
Examples of People with Overconfidence:
- “The chances that a small business will survive for five years in the United States are about 35%. But the individuals who open such businesses do not believe that the statistics apply to them. A survey found that American entrepreneurs tend to believe they are in a promising line of business: their average estimate of the chances of success for “any business like yours” was 60%—almost double the true value. The bias was more glaring when people assessed the odds of their own venture. Fully 81% of the entrepreneurs put their personal odds of success at 7 out of 10 or higher, and 33% said their chance of failing was zero.” (p. 256)
- “For a number of years, professors at Duke University conducted a survey in which the chief financial officers of large corporations estimated the returns of the Standard & Poor’s index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers of large corporations had no clue about the short-term future of the stock market; the correlation between their estimates and the true value was slightly less than zero!” (p. 261)
- The CFO’s that were most confident and optimistic in their forecast for the S and P 500, were also the most confident/optimistic in their own skill for their company.
- How do you identify which CEO’s (not CFO) are the most optimistic? The most optimistic CEO’s are the ones that put most of their personal money into their own company’s stock. The press loves overconfident CEO’s and turns them into celebrities (which makes them even more overconfident). The problem? They tend to take excessive risks and underperform. “We find that firms with award-winning CEOs subsequently underperform, in terms both of stock and of operating performance.” (p. 258)
- Philip Tetlock, a Professor at Wharton Business School, did a study on political experts. He consulted with 284 political experts and asked them to forecast political and economic trends. This study was done over a 20 year period. He gathered over 80,000 predictions.
“The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes. In other words, people who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options.” (p. 219) - Why are stock pickers so confident? Kahneman was invited by a Wall Street firm to analyze the performance of their investment advisers. Daniel analyzed the data from 25 wealth advisers for 8 consecutive years. The results showed the advisers Correlation Coefficient was .01! This means their performance had no correlation with their skill. It was luck. When he told some of these advisers they were just lucky, they refused to believe him.
An advisor said, “I have done very well for the firm and no one can take that away from me.” Kahneman smiled and said nothing. But he thought, “Well, I took it away from you this morning. If your success was due mostly to chance, how much credit are you entitled to take for it?” (p. 216) - “Overconfidence also appears to be endemic in medicine. A study of patients who died in the ICU compared autopsy results with the diagnosis that physicians had provided while the patients were still alive. Physicians also reported their confidence. The result: “clinicians who were ‘completely certain’ of the diagnosis antemortem were wrong 40% of the time.” Here again, expert overconfidence is encouraged by their clients: “Generally, it is considered a weakness and a sign of vulnerability for clinicians to appear unsure. Confidence is valued over uncertainty and there is a prevailing censure against disclosing uncertainty to patients.” (p. 263)
- “When they come together, the emotional, cognitive, and social factors that support exaggerated optimism are a heady brew, which sometimes leads people to take risks that they would avoid if they knew the odds. There is no evidence that risk takers in the economic domain have an unusual appetite for gambles on high stakes; they are merely less aware of risks than more timid people are. Dan Lovallo and I coined the phrase “bold forecasts and timid decisions” to describe the background of risk taking.” (p. 263)
- “More generally, the financial benefits of self-employment are mediocre: given the same qualifications, people achieve higher average returns by selling their skills to employers than by setting out on their own. The evidence suggests that optimism is widespread, stubborn, and costly.” (p. 257)
- “Why do investors, both amateur and professional, stubbornly believe that they can do better than the market, contrary to an economic theory that most of them accept, and contrary to what they could learn from a dispassionate evaluation of their personal experience?” (p. 217)
Some good reasons to have Overconfidence.