Entrepreneurship: When overconfidence favors riskier bets
Studies have often pointed to entrepreneurs’ excessive confidence in their own talents as an important factor in perseverance and commitment to entrepreneurship. PhD student Anisa Shyti uncovers the interactions between overconfidence and attitudes to ambiguous prospects in entrepreneurial decision-making.
Hopping into the unknown is an integral part of entrepreneurship. Maybe the quaint bed & breakfast opened with loving labour will flourish whilst the vinyl record shop next door, founded with equal passion, flounders. Or perhaps things will turn out the other way around. This uncertainty also pervades many aspects of everyday life, as HEC doctoral student Anisa Shyti points out. “The topic inspires me,” she says. “After all, when I left Albania to study in Milan, I was heading for the unknown, since I had never left my country before.” Even hospitals can sometimes only give the probable chance of success of a medical treatment. This lack of clarity regarding likelihoods of outcomes is described in decision science as ambiguity (rather than uncertainty, which suggests knowing nothing at all, probability-wise). It is also distinct from risk, where probabilities are known – as in the game of Russian roulette (playing with a known number of bullets). “It’s a very puzzling concept,” admits Anisa Shyti, “but also a promising area for management studies.” Indeed, ambiguity is very common in entrepreneurship, where it’s hard to know the odds of success of a venture, but the decision-making processes of entrepreneurs in a context of ambiguity have not been studied much. So the budding researcher decided to delve into the subject for her dissertation.
AMBIGUITY AVERSION: GOING FOR “SAFE” BETS
The angle of ambiguity is all the more interesting in a context of entrepreneurship – usually viewed as an act of audacity – as human beings tend be cautious in their gambles: as a rule, they tend to prefer options with stated probabilities (50/50 for example) over those with unknown probabilities. This phenomenon of ambiguity aversion was originally described in 1961 as “Ellsberg’s paradox.” In terms of entrepreneurship, it could translate into choosing to open a franchise such as McDonald’s – a venture almost guaranteed to succeed – as opposed to a totally new fast-food concept, therefore with more “ambiguous” chances of success, as Anisa Shyti explains. Yet experimental research (as well as real-life examples of outlets other than the famous hamburger chain) show that decision-makers are not consistently ambiguity averse. On the contrary, ambiguity attitudes of decision-makers are rich, depend on context as well as on the perceived likelihood of an event. This opens up new perspectives in the study of decision-making, in particular the role of prior beliefs (antecedents of action).
People overweigh low probabilities and underweigh high probabilities.
Anisa Shyti decided to examine the impact of overconfidence, which is one of the most important psychological biases in social sciences. She defines it as “inflated beliefs in one own chances of success related to personal skills,” pointing out that it is “a genuine feeling” (we all like to think that we are smarter than average). It is hardly surprising that most entrepreneurship studies attribute the decision to start a new business to overconfidence. After all, if people did not believe in their own business intuitions or skills they would simply remain in salaried employment rather than devoting their nights to developing new applications for iPhones or using all their savings to open a juice bar. For example, when Lucas Buick, co-founder of Hipstamatic (a revolutionary photography application for iPhone, worth $22 million in projected revenues for 2012), was asked if he would sell to Kodak, he replied: “No. I want to buy Kodak.” In order to observe the effect of overconfidence in ambiguity attitudes, the researcher designed an experiment whereby participants were “primed” for overconfidence, underconfidence, and neutral-confidence, then asked to choose between a risky prospect and an ambiguous one. On average, the overconfident decision-makers behaved as ambiguity-seekers.
As Anisa Shyti writes, individuals’ estimates about their probability of success in a given task is influenced by the sense of knowledge on the topic, the familiarity with the task, its perceived difficulty, etc.
But the researcher also found that another factor modified decision-making: the likelihood of outcomes. When levels of likelihood were low, overconfident decision-makers made less ambiguous choices. Conversely, for high likelihood prospects (higher probabilities), overconfident decision-makers increased the proportion of chosen ambiguous prospects. Anisa Shyti explains this distortion in choices through Prospect Theory, which has shown that individuals do not process probabilities linearly. “People overweight low probabilities and underweight high probabilities,” she explains. This cognitive phenomenon is called insensitivity to probabilities.
Based on Anisa Shyti’s article “Entrepreneurial choice under ambiguity and the impact of overconfidence: evidence from the lab.” It won the best paper award at the European Strategy, Entrepreneurship and Innovation 2012 Doctoral Consortium held in Copenhagen last September.
APPLICATIONS FOR THE WORKPLACE
Anisa Shyti’s research on overconfidence and ambiguity attitudes can be applied to better understand the profiles of entrepreneurs. Wealthy investors or venture capital funds in particular may want to disentangle the effects of hubris from overconfidence, since a confident, optimistic and charismatic entrepreneur would be more likely to inspire trust in his vision and therefore attract capital and other resources such as human resources.
“The feeling of overconfidence may trigger action – may prompt one to dare go where no one has been before, leading to innovation or failure.” Anisa Shyti would also suggest that for some decisions, a time trade-off could be beneficial. Entrepreneurs, in some situations may take more time to analyze, reflect and reduce ambiguity, for better decision-making. “Some ambiguity can be resolved, some unknowns are knowable, or become knowable” she says. “You can’t always reduce ambiguity, but maybe successful entrepreneurs are the ones aware of uncertainty and more ready to leverage on the unexpected – high risk for high return.”
The laboratory experiment was run with 40 volunteers from HEC’s Executive Education program. A psychological state of confidence (overconfidence, underconfidence, or neutral confidence) was induced in the participants by making them take part in a trivia quiz, the difficulty of which was manipulated. Then they had to choose between an ambiguous investment prospect, which offered a monetary reward with a probability range, for example [10% - 20%], and a risky prospect, which offered the same reward but with a given probability.