Entrepreneurial Success and Failure: Confidence and Fallible Judgment

Abstract (Via Hogarth & Karelaia)

Excess entry – or the high failure rate of market-entry decisions – is often attributed to overconfidence exhibited by entreprene urs. We show analytically that whereas excess entry is an inevitable consequence of imperfect assessments of entrepreneurial skill, it does not imply overconfidence. Judgmental fallibility leads to excess entry even when everyone is underconfident. Self-selection implies greater confidence (but not necessarily overconfidence) among those who start new businesses than those who do not and among successful entrants than failures. Our results question claims that “entrepreneurs are overconfident” and emphasize the need to understand the role of judgmental fallibility in producing economic outcomes.

Introduction (Via Hogarth & Karelaia)

If overconfidence leads to excess entry, much could be gained if entrepreneurs learned to modify their beliefs. Indeed, this is the implicit recommendation of the psychological evidence just cited. However, if entrepreneurs are not really overconfident, this advice could be counter-productive. In this paper, we do not question that the judgments of entrepreneurs are imperfect or fallible. However, fallibility does not necessarily imply overconfidence. Indeed, equating the two can lead to erroneous implications

Conclusion (Via Hogarth & Karelaia)

It is sometimes said that, whereas overconfidence is dysfunctional for individual entrepreneurs, it is functional for society in that many individual failures are necessary to achieve success at the societal level. We disagree. As we have shown, greater overconfidence implies less missed opportunities but also more failures. Skill uncertainty or judgmental fallibility plays an important role in why entrepreneurs enter businesses that fail. However, it also plays a role in why people fail to enter businesses they should have entered.Reducing skill uncertainty diminishes both missed opportunities and failures. Society would be better off as a whole if entrepreneurs were better able to estimate their abilities in both absolute and relative terms. However, this is not the same as saying excess entry is due to overconfidence.

The main implication of our work is to emphasize the importance of training potential entrepreneurs to reduce skill uncertainty. Whereas we have no precise “formula for success,” we speculate that the basis of such training should follow principles relevant to the acquisition of expertise. These involve, principally, total immersion in the domain of activity and learning to improve performance through continued practice with appropriate feedback (see, e.g., Ericsson and Charness 1994). However, this is not something that can be achieved in a short period of time. In the case of potential entrepreneurs, we believe it would involve – in addition to acquiring basic business skills – detailed studies of the specific industry of interest and many experiential exercises involving accurate feedback that can increase the entrepreneur’s awareness of her skill set – both in isolation and in comparison with others – as well as indicating paths to improvement. Just how to organize such educational experiences is an important challenge for society.

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25. November 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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