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The Overconfidence Problem in Forecasting

Richard Thaler on why anyone in business didn’t consider the possiblity 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.

It turns out that C.F.O.’s, as a group, display terrible calibration. The actual market return over the next year fell between their 80 percent confidence limits only a third of the time, so these executives weren’t particularly good at forecasting the stock market. In fact, their predictions were negatively correlated with actual returns. For example, in the survey conducted on Feb. 26, 2009, the C.F.O.’s made their most pessimistic predictions, expecting a market return of just 2.0 percent, with a lower bound of minus 10.2 percent. In fact, the market soared 42.6 percent over the next year.

It may be neither troubling nor surprising that C.F.O.’s can’t accurately predict the stock market’s path. If they could, they’d be running hedge funds and making billions. What is troubling, though, is that as a group, many of these executives apparently don’t realize that they lack forecasting ability. And, just as important, they don’t seem to be aware of how volatile the market can be, even in “normal” times.

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.

Thaler Concludes:

Two lessons emerge from these papers. First, we shouldn’t expect that the competition to become a top manager will weed out overconfidence. In fact, the competition may tend to select overconfident people. One route to the corner office is to combine overconfidence with luck, which can be hard to distinguish from skill. C.E.O.’s who make it to the top this way will often stumble when their luck runs out.

The second lesson comes from Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Read the Full article at the NYT