Richard Thaler: The Overconfidence Problem in Forecasting

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Introduction & Excerpts (via Richard Thaler & NYT)

Businesses in nearly every industry were caught off guard by the Great Recession. Few leaders in business — or government, for that matter — seem to have even considered the possibility that an economic downturn of this magnitude could happen.

What was wrong with their thinking? These decision-makers may have been betrayed by a flaw that has been documented in hundreds of studies: overconfidence.

Most of us think that we are “better than average” in most things. We are also “miscalibrated,” meaning that our sense of the probability of events doesn’t line up with reality. When we say we are sure about a certain fact, for example, we may well be right only half the time.

To see how it works, try this little quiz: Give two estimates of the diameter of the moon in miles — a high and a low one, so that there is about a 10 percent chance that the moon is bigger than the upper estimate and a 10 percent chance that it is smaller than the lower one. It is easy to be 100 percent sure by making your low guess zero and your high guess a trillion, so don’t cheat. Write down your answers before reading further.

Just like C.F.O.’s, chief executives often suffer from overconfidence, which can cause them to act unwisely. For example, in a 1986 paper, the economist Richard Roll of the University of California, Los Angeles, suggested that overconfidence, or what he called hubris, could explain why companies pay large premiums to take over other businesses. These premiums seem puzzling because the acquiring companies often don’t seem to profit from the takeovers. Professor Roll pointed out that the acquirers have typically done very well in the recent past, leading their C.E.O.’s to the mistaken belief that their success can be replicated in takeover targets once they are in charge of them.

PROFESSOR ROLL recently wrote another paper on this topic with three French collaborators. In this case, they investigated a particular form of hubris — narcissism — by using a simple and unobtrusive gauge that has been validated by psychologists: just count the number of times a person uses the first-person pronoun in communication. They found that the more narcissistic C.E.O.’s make more aggressive takeovers at higher prices than their more self-effacing brethren do, and that these aggressive takeovers aren’t as well received by the stock market.

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