Tue, Aug 24, 2010 - Page 9 News List

Over-confidence may have wrecked the global economy

Financial executives are often ‘miscalibrated,’ meaning what they know for certain is usually dead wrong

By Richard Thaler  /  NY TIMES NEWS SERVICE

Businesses in nearly every industry were caught off guard by the Great Recession. Few leaders in business — or government, for that matter — seem to have even considered the possibility 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 does not 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.

To see how it works, try this little quiz: Give two estimates of the diameter of the moon in kilometers — a high and a low one, so that there is about a 10 percent chance that the moon is bigger than the upper estimate and a 10 percent chance that it is smaller than the lower one. It is easy to be 100 percent sure by making your low guess zero and your high guess a trillion, so do not cheat. Write down your answers before reading further.

When faced with questions like this in experiments, people tend to give confidence bounds, or limits, that are too narrow. In other words, the correct answer is outside their limits much more than 20 percent of the time, creating too many surprises. (The answer to the moon question, by the way, is 3,475km. Were you surprised?)

Some economists have questioned whether such experimental findings are relevant in competitive markets. They suggest that students, who often serve as guinea pigs in such tests, are overconfident, but that the top managers in large companies are well calibrated. However, a recent paper reveals that this hopeful view is itself overconfident.

In that paper, three financial economists — Itzhak Ben-David of Ohio State University and John Graham and Campbell Harvey of Duke — found that chief financial officers (CFO) of major US corporations are not very good at forecasting. The authors’ investigation used a quarterly survey of CFOs that Duke has been running since 2001.

Among other things, the CFOs were asked about their expectations for the return of the Standard & Poor’s 500-stock index for the next year — both their best guess and their 80 percent confidence limit. This means that in the example above, there would be a 10 percent chance that the return would be higher than the upper bound, and a 10 percent chance that it would be less than the lower one.

It turns out that CFOs, 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 were not 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 last year, the CFOs made their most pessimistic predictions, expecting a market return of just 2 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 CFOs cannot accurately predict the stock market’s path. If they could, they would be running hedge funds and making billions of US dollars. What is troubling, though, is that as a group, many of these executives apparently do not realize that they lack forecasting ability. And, just as important, they do not seem to be aware of how volatile the market can be, even in “normal” times.

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