In a study conducted in 1980 drivers were surveyed about their driving skills in comparison to a group of others. In her experiment, Svenson analyses how people judge their own skill and risk taking engaged in risky activities.
The result of the experiment shows that 88% of US subjects and 77% of Swedish subjects judged their skills above the average skill in their subject group. Preston and Harris (1965) indicate even more bias from subjects. They compared 50 drivers which were involved in accidents, besides being hospitalized, they still showed means stating that they judged themselves more skillful than the average driver.
The central element of the economic paradigm is homo economicus. Homo economicus is described as an individual with rational actions. The homo economicus faces a situation with limited resources to satisfy his needs. Therefore, the homo economicus uses rational decisions to optimize his outcome and gain the highest utility possible. Behavioral economic research on the other hand distinguishes a deviance of human behavior from the rational homo economicus as can be observed in Svenson’s study. The behavior is called overconfidence, which is a widely discussed phenomenon in behavioral economic literature. Psychological studies show that most people are overconfident about their own relative abilities, tend to underestimate their competition and make unreasonably optimistic predictions about their futures. In the following, the characteristics of the behavioral model of overconfidence will be further discussed. Subsequently, the influence of overconfidence on risk taking will be evaluated.
1. Introduction
“Are your driving skills above average?”
In a study conducted in 1980 drivers were surveyed about their driving skills in comparison to a group of others. In her experiment, Svenson analyses how people judge their own skill and risk taking engaged in risky activities.
The result of the experiment shows that 88% of US subjects and 77% of swedish subjects judged their skills above the average skill in their subject group (Svenson 1981, 146). Preston and Harris (1965) indicate even more bias from subjects. They compared 50 drivers which were involved in accidents, besides being hospitalized, they still showed means stating that they judged themselves more skillful than the average driver (Svenson 1981, 147).
2. Behavioral model of Overconfidence
The central element of the economic paradigm is homo economicus. Homo economicus is described as an individual with rational actions. The homo economicus faces a situation with limited resources to satisfy his needs. Therefore, the homo economicus uses rational decisions to optimize his outcome and gain the highest utility possible. (Mathis and Shannon 2009, 7-30). Behavioral economic research on the other hand distinguishes a deviance of human behavior from the rational homo economicus as can be observed in Svenson’s study. The behavior is called overconfidence, which is a widely discussed phenomenon in behavioral economic literature. Psychological studies show that most people are overconfident about their own relative abilities, tend to underestimate their competition and make unreasonably optimistic predictions about their futures (Neil D. Weinstein 1980, 806). In the following, the characteristics of the behavioral model of overconfidence will be further discussed. Subsequently, the influence of overconfidence on risk taking will be evaluated.
3. Empirical evidence
3.1 Men and overconfidence
Psychological research states men are more overconfident than women, and moreover men trade more excessively than women. To test this prediction Barber and Odean used data from over 35,000 households from a large brokerage firm.
Rational investors (homo economicus) only trade and purchase information when doing increases their expected utility (Grossman; Stiglitz 1980, 395). In contrast, overconfident Investors tend to trade excessively, show overoptimism towards returns and therefore lower their expected utility.
Barber and Odeans findings are consistent with the predictions and show that in summary men are more overconfident in terms of expected returns, men trade excessively and lower their returns by doing so. Even more relevant is, that in summary men tend to hold riskier positions than women, by investing in smaller stocks with higher market risk (Barber; Odean 1991, 266)
A limitation of the study is the evaluation of private investors instead of investigating the behavior of female professional traders. In a professional field, the tendency of women to act overconfident may show different results.
3.2 Overconfidence in relative skill and reference group neglect
In their experimental study about overconfidence and excess entry, Camerer and Lovallo researched business failure as a result of managers acting on the optimism about relative skill and the reference group neglect phenomenon.
The reference group neglect phenomenon describes a situation where subjects who are confident about their skills, neglect the fact that they are facing a group of subjects with the same assumptions about their own skills.
Subjects (Students with business majors) were recruited from the University of Chicago and Wharton school.
A group of player N decide (without any form of interaction or communication) whether to enter a market or not, where an increasing number of entrants leads to a decrease in return. Earlier experiments by Kahneman and Rapoport were extended by four design adjustments. Payoffs depend on a subject’s rank (relative to other entrants); 1. Payoffs depend a randomized ranking. 2. Payoffs depend on a skill-based ranking. 3. In some experiments subject are told in advance that the rank depends on skill (this leads to a higher number of players who judge their skills presumably high) 4. Subjects forecast the number of entrants in each round.
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- Quote paper
- Christopher Knoll (Author), 2016, Overconfidence and its Influence on Risk, Munich, GRIN Verlag, https://www.grin.com/document/1152399
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