Optimistic overconfidence refers to the common tendency of people to overestimate their ability to predict and control future outcomes.
Amos Tversky & Daniel Kahneman
In the first part of this article, we have talked about overconfidence from psychology. Then, in the second part, we will tell you how it affects the financial markets and the administration. Now we will continue with overconfidence and business, finance and the economy.
This article arises from Behavioral Economics and to give it the rigor of Psychology, in Steering Bird, online advisers in business direction, management and finance, we have worked together with Tu Mejor Tú, metas clatas para el éxito.
Overconfidence in Budget, Forecast and Projects
The illusion that we understand the past fosters overconfidence in our ability to predict the future.
Do you think your projections are correct? In the first part, we talk about the study Knowing with Certainy: The Appropriateness of Extreme Confidence (1977) carried out by Baruch Fischhoff, Paul Slovic and Sarah Lichtenstein. They concluded that the people who indicated that they were sure they were right, were only 80% correct. Whenever you work on a business plan, budget or forecast, you work with uncertainty. As you can see, the odds of hitting your own projections are not always in your favor.
In this regard, Daniel Kahneman indicates in the book “Thinking Fast and Slow” (2011) that for years, Duke University conducted a survey, where CFOs of large corporations estimated the returns of the Standard & Poor’s index for the following year. They analyzed 11,600 forecasts and the conclusion was: “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! When they said the market would go down, it was slightly more likely than not that it would go up. These findings are not surprising. The truly bad news is that the CFOs did not appear to know that their forecasts were worthless”
In addition with delivering their forecast on the S&P, the CFOs estimated:
- a value that they were 90% sure of would be too high, and
- a value that they were 90% sure of would be too low.
With this data, an “80% confidence interval” is constructed and the results that fall outside this range are called “surprises”
Kahneman (2011) indicates that “an individual who sets confidence intervals on multiple occasions expects about 20% of the outcomes to be surprises. As frequently happens in such exercises, there were far too many surprises; their incidence was 67%, more than 3 times higher than expected. This shows that CFOs were grossly overconfident about their ability to forecast the market”
Not only the CFOs of large corporations can be victims of overconfidence, but also anyone involved in a planning process, budget, forecast, business plan or project. You can also fall in your estimations of future values.
Regarding projects, remember the last one in which you participated and that it finished within the planned period and under the estimated budget. Include both your personal projects and your business projects. Do you have a hard time remembering one? Keep thinking, take your time. You may not remember a project on time and on budget, because it took longer or because you spent more money. Estimates are generally too optimistic.
I have a great record against anybody right now, so it doesn’t really matter who I play in the final. I’ll be in there as the big favorite. But I play my best in the finals, in the important matches. That’s why I’m number one. There’s no secret…I’m not overconfident, but very confident.
Now let’s look at start-ups or entrepreneurs. Many of them know that the odds of success are against them, but they try anyway. If people were not confident, they would hardly start a new business. This is correct. The problem is when the entrepreneur is a victim of overconfidence.
About this, in the book “Why Smart people make big money mistakes” (2009), Gary Belsky and Thomas Gilovich indicate “that their optimism is out of place, that they are too confident, it is evidenced by the fact that half of all small businesses fail within five years of creation. Put another way, most small business owners believe they have what it takes to overcome obstacles to success, but most are wrong”
It is one thing to have confidence and the courage to undertake. It is quite another to become overconfident and become a motivated fool, hovering toward failure. We want your business to work, so we want you to be aware of this potential problem.
We’re generally overconfident in our opinions and our impressions and judgments.
Do not forget that in the first part of this article we indicated that, as pointed out by Dagmar Strahlberg and Anne Maass in the study “Hindsight bias: impaired memory or biased reconstruction” (1998), overconfidence could have a retrospective bias: the tendency of people to think they should know something would happen before it happened Just as the world is full of people who think they know more than they know, it is also full of people who tell you “I knew it”.
In our article Skill vs. Luck (part 3) we had already subtly told you about some effects of overconfidence. Let us remember the following:
- People rely too much on their expertise to automate decision making. As we age, we tend to avoid overthinking the decisions we must make. Thus, we rely on some general rule that has worked for us before and apply it. We trust cause and effect based on observations.
- Organizations suffer the same effect. They become less flexible, slower, and inefficient with age. They fall into entropy. One symptom is that companies try to balance their presence in profitable markets (known, short-term success) with entering new markets (uncertainty, no immediate success). Like people, organizations also often rely on rules of thumb that have worked in the past rather than making any changes.
Overconfidence is a very broad topic, which can open up too many variables. The important issue is that you can identify it and take action on it. What actions? Among others, you should:
- analyze situations,
- diversify risks,
- seek an external and independent opinion.
Here, we can help you.
We are Steering Bird, online advisers in business direction, management and finance. We specialize in business analysis, control and analysis of investment projects, results analysis, processes of budget and forecast, etc.
This article has been written in conjunction with the team of Tu Mejor Tú, Metas claras para el éxito. We invite you to visit their website, know their services, articles and to contact them if you need their help.