Tag Archives: Overconfidence

No Overconfidence?

New data question the claim that people tend to overestimate their abilities:

A large body of literature purports to find that people are generally overconfident. In particular, a better-than-average effect in which a majority of people claim to be superior to the average person has been noted for a wide range of skills, from driving, to spoken expression, to the ability to get along with others, to test taking on simple tests. The literature generally accepts that this better-than-average effect is indicative of inflated self- assessments. However, [we] recently … show that the better-than-average data … does not indicate … people have made some kind of error in their self-evaluations.  Because of this reason, almost none of the existing experimental literature on relative overconfidence can actually claim to have found overconfidence. … In this paper, we report on an experiment designed to provide a proper test of overconfidence. … As in much previous experimental work, we find a better-than-average effect among our subjects. … We find evidence that subjects are uncertain of their own types. Our experiment can be viewed as a test of the null hypothesis that people are behaving rationally (and are not overconfident). We cannot reject that hypothesis.
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Entrepreneurs Are Not Overconfident

Not too long ago, the well-known economist Robert Hall presented this paper (co-authored with Susan E. Woodward) at my place of work.  Here is the abstract:

In the standard venture capital contract, entrepreneurs have a large fraction of equity ownership in the companies they found and are paid a sub-market salary by the investors who provide the money to develop the idea.  The big rewards come only to those whose companies go public or are acquired on favorable terms, forcing entrepreneurs to bear a substantial burden of idiosyncratic risk.  We study this burden in the case of high-tech companies funded by venture capital.  Over the past 20 years, the typical venture-backed entrepreneur earned an average of $4.4 million from companies that succeeded in attracting venture funding.  Entrepreneurs with a coefficient of relative risk aversion of two and with less than $0.7 million would be better off in a salaried position than in a startup, despite the prospect of an average personal payoff of $4.4 million and the possibility of payoffs over $1 billion.  We conclude that startups attract entrepreneurs with lower risk aversion, higher initial assets, preferences for entrepreneurship over employment, and optimistic beliefs about the payoffs from their products.

During the seminar it occurred to me that these results, assuming they are correct, are evidence of an absence of overconfidence, at least among the kinds of people who leave good jobs to form high-tech startups.  The reason is that if potential entrepreneurs were massively overconfident, one would expect to see lots of entry of startups based on weak ideas, which would lead to an expected payoff so low that forming a startup would be a losing proposition for the potential entrepreneur unless he/she started out extremely wealthy and/or had very low risk-aversion.  But what the authors actually find is that forming a startup with an average-quality idea* is a break-even proposition for a potential entrepreneur with quite modest wealth and with a more-or-less standard degree of risk-aversion.

After the talk, I asked Professor Hall if he agreed with this interpretation (he seemed to), and if he would object to my posting about it on OB (he didn't).  But I will make him aware of this post, and invite him to comment if he would like, and correct any mistakes that I might have made.

*The authors have no way to distinguish the quality of an idea, so there is an implicit assumption that the marginal quality of the idea is equal to the average quality of all ideas that actually get implemented.
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Luck Pessimism

While we tend to be optimistic about our abilities, we are pessimistic about our luck:

We analyze the answers of a sample of 1,540 individuals to the following question "Imagine that a coin will be flipped 10 times. Each time, if heads, you win 10C. How many times do you think that you will win?" The average answer is surprisingly about 3.9 which is below the average 5, and we interpret this as a pessimistic bias. We find that women are more "pessimistic" than men, as are old people relative to young.

Added:  Benja Fallenstein notes "if there is no [personal] gain associated to the coin tossing, the average [guess] is 4.9, and 90% answer 5.

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Convenient Overconfidence

We are more overconfident on tasks we don’t actually expect to perform, and when we don’t expect to have to explain our evaluation to others.  On expecting to perform:

Participants made predictions about performance on tasks that they did or did not expect to complete.  In three experiments, participants in task-unexpected conditions were unrealistically optimistic: They overestimated how well they would perform, often by a large margin, and their predictions were not correlated with their performance. By contrast, participants assigned to task-expected conditions made predictions that were not only less optimistic but strikingly accurate. Consistent with predictions from construal level theory, data from a fourth experiment suggest that it is the uncertainty associated with hypothetical tasks, and not a lack of cognitive processing, that frees people to make optimistic prediction errors.  Unrealistic optimism, when it occurs, may be truly unrealistic; however, it may be less ubiquitous than has been previously suggested.

On expecting to explain

Accountability … [is] the expectation to explain, justify, and defend one’s self-evaluations (grades on an essay) to another person ("audience"). Experiment 1 showed that accountability curtails self-enhancement. Experiment 2 ruled out audience concreteness and status as explanations for this effect. Experiment 3 demonstrated that accountability-induced self-enhancement reduction is due to identifiability. Experiment 4 documented that identifiability decreases self-enhancement because of evaluation expectancy and an accompanying focus on one’s weaknesses.

It is almost as if we at some level realize that our overconfidence is unrealistic.

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Experience Increases Overconfidence

The latest Journal of Prediction Markets has a lit review on overconfidence, with a to-me surprising result: financial overconfidence increases with age, experience, and success.  Here are three investment experiments:

Kirchler and Maciejovsky (2002) …. demonstrated that subjects were overconfident in late trading periods … [but] underconfident during other trading periods. … Dittrich et al (2005) … found that age was positively correlated to overconfidence for complex tasks.  … Glaser et al (2005) … [found that financial market] professionals’ degrees of overconfidence was higher than that of the student subjects in most tasks, and it appeared that was because the "professionals are biased in job related tasks, such as forecasting real world financial time series."

Also:

A survey of German stock market forecasters conducted by Deaves et al (2005) … demonstrated that the market forecasters were overconfident in their predictions and that greater market experience and success, measured by correct predictions, increased their overconfidence.  … Markets are likely to become more overconfident when market returns are high. 

This is disturbing.  If overconfidence is positively correlated with ability, then observers can rationally take overconfidence as a signal of ability, and people can want to appear more overconfident to appear more able.  But to make this story work, somehow it should on average be easier to get away with being more overconfident when one is more experienced and successful.  How can this be?

This all seems to make it more reasonable than one might otherwise have thought to disagree about finance with older, more experienced, more successful folks.

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Joe Epstein on Youth

More on our overconfident kids from a thoughful essay by Joseph Epstein:

So often in my literature classes students told me what they "felt" about a novel, or a particular character in a novel. I tried, ever so gently, to tell them that no one cared what they felt; the trick was to discover not one’s feelings but what the author had put into the book, its moral weight and its resultant power. In essay courses, many of these same students turned in papers upon which I wished to–but did not–write: "D-, Too much love in the home." I knew where they came by their sense of their own deep significance and that this sense was utterly false to any conceivable reality. Despite what their parents had been telling them from the very outset of their lives, they were not significant. Significance has to be earned, and it is earned only through achievement. Besides, one of the first things that people who really are significant seem to know is that, in the grander scheme, they are themselves really quite insignificant.

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Overconfidence & Paternalism

Paul Graham tries to explain paternalism: 

Parents know they’ve concealed the facts about sex, and many at some point sit their kids down and explain more. But few tell their kids about the differences between the real world and the cocoon they grew up in. Combine this with the confidence parents try to instill in their kids, and every year you get a new crop of 18 year olds who think they know how to run the world.

Don’t all 18 year olds think they know how to run the world? Actually this seems to be a recent innovation, no more than about 100 years old. In preindustrial times teenage kids were junior members of the adult world and comparatively well aware of their shortcomings. They could see they weren’t as strong or skillful as the village smith. In past times people lied to kids about some things more than we do now, but the lies implicit in an artificial, protected environment are a recent invention. Like a lot of new inventions, the rich got this first. Children of kings and great magnates were the first to grow up out of touch with the world. Suburbia means half the population can live like kings in that respect.  …

Continue reading "Overconfidence & Paternalism" »

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Sincerity Is Overrated

Consider choices like:

  • Do I push folks at my large company to hire my son?
  • Do I spend college money from my parents to pursue an acting career?
  • Do cut open this patient to try my new surgical technique?

Such choices might be justified if, for example,

  • My son is really good fit for the job opening.
  • I have an excellent chance to succeed in acting.
  • This is a very promising surgical technique.

But when am I justified in having such beliefs?  Most people think they are justified in acting on a belief if that belief is "sincere."  And by "sincere" they mean they are not conscious of just pretending to believe.  When they go to the shelf in their mind where that belief is suppose to sit, this is what they find.  And they don’t remember anything illicit about how that belief got there.

But sincerity is way too low a standard!  Since humans have an enormous tendency toward self-deception, wishful thinking, and so on, we are clearly "sincerely" biased in many ways.  So to be justified in acting on a belief, you must have tried to identify and overcome relevant biases.  Furthermore, your efforts should be proportionate to the magnitude of the actions being considered, and to the magnitude of the biases that could distort your beliefs.  For important actions where biases tend to be large, you must try very hard to consider what you might have seen and felt if the world were other than you think it is. 

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Knowing your argumentative limitations, OR “one [rationalist’s] modus ponens is another’s modus tollens.”

Followup to: Who Told You Moral Questions Would be Easy?Response to: Circular Altruism

At the most basic level (which is all we need for present purposes), an argument is nothing but a chain of dependence between two or more propositions.  We say something about the truth value of the set of propositions {P1…Pn}, and we assert that there’s something about {P1…Pn} such that if we’re right about the truth values of that set, we ought to believe something about the truth value of the set {Q1…Qn}. 

If we have that understanding of what it means to make an argument, then we can see that an argument doesn’t necessarily have any connection to the universe outside itself.  The utterance "1. all bleems are quathes, 2. the youiine is a bleem, 3. therefore, the youiine is a quathe" is a perfectly logically valid utterance, but it doesn’t refer to anything in the world — it doesn’t require us to change any beliefs.  The meaning of any argument is conditional on our extra-argument beliefs about the world.

One important use of this principle is reflected in the oft-quoted line "one man’s modus ponens in another man’s modus tollens."  Modus ponens is a classical form of argument: 1. A–>B.  2.  A. 3.  .: B.  Modus tollens is this: 1.  A–>B.  2. ¬B.  3. .: ¬A.  Both are perfectly valid forms of argument!  (For those who aren’t familiar with the standard notation, the horizontal line is meant to indicate negation.)  Unless you have some particular reason outside the argument to believe either A or B, you don’t know whether the claim A–>B means that B is true, or that A isn’t true! 

Why am I elucidating all this basic logic, which almost everyone reading this blog doubtless knows?  It’s a rhetorical tactic: I’m trying to make it salient, to bring it to the top of the cognitive stack, so that my next claim is more compelling.

And that claim is as follows:

Eliezer’s posts about the specks and the torture [1] [2], and the googleplex of people being tortured for a nanosecond, and so on, and so forth, tell you nothing about the truth of your intuitions.

Argument behind the fold…

Continue reading "Knowing your argumentative limitations, OR “one [rationalist’s] modus ponens is another’s modus tollens.”" »

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CFO Overconfidence

A recent NBER paper:

We test whether top corporate executives are miscalibrated, and whether their miscalibration impacts investment behavior. Over six years, we collect a unique panel of nearly 7,000 observations of probability distributions provided by top financial executives regarding the stock market. Financial executives are miscalibrated: realized market returns are within the executives’ 80% confidence intervals only 38% of the time. We show that companies with overconfident CFOs use lower discount rates to value cash flows, and that they invest more, use more debt, are less likely to pay dividends, are more likely to repurchase shares, and they use proportionally more long-term, as opposed to short-term, debt.

It would be relatively easy to measure overconfidence in CFO candidates, and choose less overconfident ones.  Since this doesn’t happen, I suspect that CEOs, like bosses of software managers, prefer overconfident CFOs.

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