• Overhalf of entrepreneurs overestimate their development potential when they first create their business. Only 5% underestimate this factor.
• Entrepreneurs’convictions and their financial decisions are positively correlated. Realists generally opt for long term financing plans, whereas optimists tend to choose seemingly less costly, short-term financing solutions.
In recent years, psychology has made inroads into economics research, with widely recognized benefits. Psychology provides insights into why economic players behave and, especially, think the way they do. The 2002 recipient of the Nobel Prize for economics was psychologist Daniel Kahneman, who was honored for his work on decision-making and judgment under conditions of uncertainty. David Thesmar and Augustin Landier have continued in this direction. In the study presented here, they looked at psychological explanations of why certain people create new businesses, and how psychological factors influence entrepreneurs’ financial decisions.
CREATING A COMPANY: AN IRRATIONAL CHOICE?
Numerous empirical studies indicate that entrepreneurs generally earn far less in their own company than they would if they were employed elsewhere. This is because, above and beyond the question of salary, creating your own company requires heavy personal investments of time, energy, and even possessions. So why do it? Why do some people make the apparently irrational decision to start their own business? Cognitive psychology provides two explanations of what motivates such choices. The first has to do with the desire for independence, and the second with people’s belief systems. Specifically, optimism makes entrepreneurs overestimate the likelihood of success. Thesmar and Landier have explored this idea in their research.
OPTIMISM AND MISPERCEPTION
By definition, optimists believe in their capacity for success. That does not mean that they believe their every undertaking will be successful, but rather that they simply underestimate the likelihood of failure. Thesmar and Landier’s study reveals this tendency among entrepreneurs. When they create their businesses, only 5%underestimate their new company’s future development, while over 50% overestimate it. Thesmar and Landier show that such misjudgment is habitual. Indeed, entrepreneurs are eternal optimists.
PROFILE OF AN OPTIMIST
Thesmar and Landier’s study reveals a number of socio-demographic characteristics that are related to entrepreneurs’ overriding optimism (or their tendency to overestimate their chances of success).
• Education: People who have earned advanced degrees are more likely to believe they are generally capable of handling whatever comes up.
• New ideas: People who have created their own business because they have come up with an innovative idea are especially optimistic about their development potential.
• Gender: Men are more optimistic than women. This finding fits with the results of a number of studies showing that men tend to overestimate the accuracy of their judgment.
• Business creation: People who create new companies are more optimistic than those who take over existing firms. The latter are often taking advantage of an opportunity (like a succession), and they generally evaluate their situation more realistically.
• Experience: People who already have experience in a field of activity* are less optimistic. In fact, experience often has contradictory effects. It sometimes makes people overconfident, but it also gives them a better understanding of their environment and makes them more aware of inherent risks. On the whole, the latter situation seems to be the most common.
MINDSET AND FINANCIAL DECISIONS
Thesmar and Landier have developed a model that considers both realistic and optimistic entrepreneurs and explains how people’s mindset affects the credit market. They show that a balance is created, as optimists choose short-term loan solutions, while realists opt for longer-term financing schemes. Indeed, because optimists underestimate the likelihood of failure, they believe they will generate income immediately and will thus be able to reimburse short-term loans. On the contrary, pessimists expect to run into trouble, and therefore select financing schemes that will enable them to adapt to negative turns of events and if necessary renegotiate their loan. Thesmar and Landier’s empirical studies confirm these hypotheses. Examining both entrepreneurs’mindsets and their capital financing plans reveals that expectations of success and financial choices are correlated.
Based on an interview with David Thesmar and on his article, “Financial contracting with optimistic entrepreneurs” , Review of Financial Studies , January 2009, vol. 22, n° 1, pp. 117-150 co-authored with Augustin Landier, professor at the Toulouse School of Economics. Thesmar’s research focuses on corporate finance and governance, assetmanagement, the economics of organizations, and behavioral finance.
* In this study, the authors defined this as experience in a given industry.
This article focuses on differences in perception among various economic players. When it comes to business creation, people who dare to go out on their own tend to misjudge what lies ahead and therefore take greater risks. So between a short-term loan with a 4% interest rate and a long-term loan at 8%, such people are likely to choose the former. They think this will be the least costly solution, because they expect to be able to reimburse their debt quickly. In fact, they overestimate their chances of success and are willing to give personal guarantees or to run the risk of extra fees that actually increase their business costs. Bankers take advantage of such erroneous reasoning. The study also shows that entrepreneurs often have warped views of reality. It is therefore crucial to increase their awareness of psychological biases and how they affect decision-making. In other words, entrepreneurs must realize that their optimistic mindset may cause them to make poor financial choices.
The researchers examined the results of the 1994 and 1998 SINE (new business information system) studies produced by the INSEE (French national institute for statistics and economic studies). The studies involved 30,778 and 30,068 French entrepreneurs, respectively. Three years after the initial interviews, entrepreneurs were questioned again. They provided socio-demographic information (age, educational background, etc.) as well as information about their initial motivation, expectations, and plans (“I will develop the business”, “I will hire more people”, etc.). The researchers used INSEE information to measure “entrepreneurial optimism” by comparing people’s initial expectations with their actual business results (income and people growth).