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

Another intriguing finding is that their confidence limits widen after bear markets, mostly because estimates at the lower bound become more pessimistic. This puts a new light on the recent comment by US Federal Reserve Chairman Ben Bernanke that the economic outlook was “unusually uncertain.”

Although I instinctively share that assessment, these results suggest that it may be an illusion: Yes, things feel more uncertain after bad times, but severe market downturns tend to occur after long bull markets when we are feeling least uncertain. In the CFO survey conducted in mid-2007, for example, the average lower bound was for a market return of 0.2 percent in the next year. In other words, the worst-case scenario anticipated by the group was a flat market. Of course, the market was soon to begin its plunge.

Just like CFOs, 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 do not seem to profit from the takeovers. Roll said that the acquirers have typically done very well in the recent past, leading their chief executive ­officers to the mistaken belief that their success can be replicated in takeover targets once they are in charge of them.

Roll recently wrote another paper on this topic with three French collaborators. In this case, they investigated a particular form of hubris — narcissism — by using a simple and unobtrusive gauge that has been validated by psychologists: Just count the number of times a person uses the first-person pronoun in communication. They found that the more narcissistic chief executives make more aggressive takeovers at higher prices than their more self-effacing brethren do, and that these aggressive takeovers are not as well received by the stock market.

Two lessons emerge from these papers. First, we should not 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. Chief executives 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.”

Richard Thaler is a professor of economics and behavioral science at the University of Chicago’s Booth School of Business.

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