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.
Table of Contents
1. Introduction
2. Behavioral model of Overconfidence
3. Empirical evidence
3.1 Men and overconfidence
3.2 Overconfidence in relative skill and reference group neglect
3.3 The self-serving bias
3.4 Myopia and loss aversion
3.5 The value of Information on trading behavior
3.6 The survival of overconfident traders
3.7 The impact of experience on risk taking
4. Discussion
5. Conclusion and Implication
Objectives & Core Themes
The primary objective of this seminar paper is to examine the behavioral economic model of overconfidence and evaluate its profound influence on individual and organizational risk-taking behavior in financial and competitive environments.
- Theoretical foundations of overconfidence vs. the rational homo economicus.
- Empirical analysis of gender differences and reference group neglect.
- Impact of cognitive biases, such as self-serving bias and myopic loss aversion, on decision-making.
- The role of information and experience in moderating or exacerbating overconfidence in trading.
- Economic consequences of overconfidence, including market failures and excessive risk-taking.
Excerpt from the Book
3.3 The self-serving bias
The self-serving-bias research is an addition the overestimation of individual skill and the reference group neglect phenomenon in the economic behavior of overconfidence. In general, people make positive attributions for desired outcomes and negative attributions for undesired outcomes. Babcock and Loewenstein explained the role of self-serving biases in bargaining impasse by conducting an experiment, where subjects (80 undergraduates from the University of Chicago and 80 law students at the University of Austin) were assigned randomly to roles as either defendant or plaintiff. After examining the files of a tort case, based on a trial that occurred in Texas, in which an injured motorcyclist sued the driver of the automobile that collided with him, requesting $100,000. Subjects were asked to write down their guess of what the judge awarded. The outcomes showed strong evidence that the subjects formed self-serving assessments in which Plaintiffs’ predicted the judge’s decision in average $14,527 higher than defendants’ (Babcock; Loewenstein 1997, 5)
When extended to an organizational level, self-serving bias can lead to overoptimistic planning in the future. Larwood and Whittaker tested this prediction with two groups of management students and a group of corporate presidents. Students were assigned the role of a sales manager and asked to predict the sales of a new product in a competitive market. The subjects judged sales growth as a valid factor of success and predicted that their own firm would do better than the other subjects’. Because corporate managers are more bound to realistic planning, Larwood and Whittaker expected a more moderate outcome for the managers.
Chapter Summary
1. Introduction: This chapter introduces the phenomenon of overconfidence, specifically using driving ability studies to demonstrate the tendency of individuals to overestimate their relative skills.
2. Behavioral model of Overconfidence: This section contrasts the rational homo economicus model with behavioral observations, defining overconfidence as a significant deviation from rational decision-making.
3. Empirical evidence: This chapter provides a comprehensive analysis of various psychological and economic studies demonstrating how overconfidence manifests in trading, management, and risk assessment.
3.1 Men and overconfidence: Examines how gender differences in overconfidence lead to excessive trading and higher risk exposure among men compared to women.
3.2 Overconfidence in relative skill and reference group neglect: Analyzes how managers often ignore the competition's skill levels, leading to business failure and excessive market entry.
3.3 The self-serving bias: Explores how individuals make biased attributions for success and failure, and how this influences bargaining and organizational planning.
3.4 Myopia and loss aversion: Investigates the combination of frequent outcome evaluation and loss sensitivity as a driver of poor financial risk-taking.
3.5 The value of Information on trading behavior: Discusses how the acquisition of information can paradoxically lead to both more rational and more overconfident trading behavior.
3.6 The survival of overconfident traders: Explores the conditions under which overconfident traders can coexist with rational traders in a competitive market.
3.7 The impact of experience on risk taking: Evaluates whether increased professional experience reduces overconfidence and herd behavior in fund management.
4. Discussion: Synthesizes the findings, highlighting the discrepancies between experimental results and professional market behavior, and critiques the representativeness of student-based samples.
5. Conclusion and Implication: Concludes that overconfidence leads to excessive risk-taking and utility loss, necessitating further research into debiasing measures to prevent economic failures.
Keywords
Overconfidence, Behavioral Economics, Homo Economicus, Risk Taking, Self-serving Bias, Myopic Loss Aversion, Financial Markets, Trading Behavior, Reference Group Neglect, Information Acquisition, Herd Behavior, Asset Pricing, Economic Failure, Decision Theory.
Frequently Asked Questions
What is the core focus of this research paper?
The paper focuses on the behavioral economic model of overconfidence and its measurable impact on risk-taking in various economic and competitive contexts.
What are the primary themes covered in the work?
The themes include the psychological roots of overconfidence, gender differences in financial trading, organizational planning failures, the role of cognitive biases like loss aversion, and the survival of irrational agents in markets.
What is the central research question?
The paper explores how overconfidence influences individuals' risk-taking behavior and whether this behavior leads to suboptimal economic outcomes.
Which scientific methods were utilized for the analysis?
The work employs a literature-based synthesis and comparative analysis of various psychological and experimental economic studies to evaluate the prevalence and consequences of overconfidence.
What is addressed in the main part of the paper?
The main part covers empirical evidence regarding specific biases (self-serving bias, myopic loss aversion), the impact of information and experience on trading, and the competitive survival of overconfident traders.
Which keywords characterize this work?
Key terms include overconfidence, behavioral economics, financial risk-taking, loss aversion, and trading behavior.
How does the "reference group neglect" phenomenon affect business managers?
It leads managers to focus on their own perceived skill while ignoring that competitors possess similar abilities, which often results in excessive market entry and failure.
Does increased professional experience necessarily eliminate overconfidence?
The results are not entirely clear-cut; while some research suggests experience decreases herd behavior, other studies show that experienced managers remain prone to overoptimistic forecasting.
What is the relationship between gender and trading behavior?
The paper cites evidence suggesting that men tend to be more overconfident than women, leading them to trade more excessively and hold riskier asset positions.
- Arbeit zitieren
- Christopher Knoll (Autor:in), 2016, Overconfidence and its Influence on Risk, München, GRIN Verlag, https://www.grin.com/document/1152399
