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Overconfidence in Sheep's Clothing

By Anthony Cerminaro

"What else can psychology tell us about running a business?

"One example... [is] 'the illusion of validity.' This is the sense that you have that you understand somebody and you can predict how they will behave. The reason I call this the illusion of validity is that we knew from the statistics that we were actually not able to predict how people would behave...That's a very important illusion--this illusion of validity. In many different forms, it has big implications.

"Such as?

"One of the versions of it is called overconfidence: People assign much higher probability to the truth of their opinions than is warranted. It's one of the reasons people trade so much in the market, generally with bad results. [Another example is people] exaggerate their confidence in their plans--something we call the planning fallacy.... The existence of the plan tends to induce overconfidence.

"But isn't confidence a good thing?

"It's a wonderful thing to be optimistic. It keeps you healthy and it keeps you resilient. But I personally would not want my financial adviser to be optimistic; I'd like him to be as realistic as possible. There are contexts where optimism helps. Generally where it helps is in executing plans. It keeps you on track. It gives you energy to overcome obstacles....

"In many cases, what looks like risk-taking is not courage at all, it's just unrealistic optimism. Courage is willingness to take the risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don't know the odds. It's a big difference."

Read more in this inteview with Nobel Laureate Daniel Kahneman.

Full post as published by Bizz Bang Buzz Blawg on March 05, 2008 (boomark / email).