Unrealistic Optimism Drives Profitability

Overconfident decision-making in financial markets led to myriad negative consequences in the past decade, when companies underestimated business risks. 

Gilles Hilary

Gilles Hilary

In contrast to overconfidence, unrealistically optimistic judgments can result in increased profitability and market value, according to INSEAD’s Gilles Hilary and Benjamin Segal with Charles Hsu of Hong Kong University of Science & Technology.

Benjamin Segal

Benjamin Segal

Hilary, Hsu, and Segal demonstrated that over-optimism differs from overconfidence, and may result in larger growth projections.

Charles Hsu

Charles Hsu

The team drew on earlier work by University of Illinois’s Dirk Hackbarth that showed both overconfident, and overoptimistic managers chose higher debt levels and issued more new debt.
Hackbarth did not differentiate over-confident and over-optimistic investment behaviors, and reported that both tendencies reduce manager-shareholder conflict, which can increase firm value.

Dirk Hackbarth

Dirk Hackbarth

Static over-optimism” refers to an unrealistically positive view of the impact of one’s own actions on future outcomes.
In contrast, “dynamic overconfidence” refers to overvaluation of one’s skills and the accuracy of private information.
In addition, “dynamic overconfidence”  is associated with  underestimates of random events after several positive outcomes, according to Hackbarth.

Together, static over-optimism and dynamic overconfidence lead to “dynamic over-optimism” after successes.

Neil Weinstein

Neil Weinstein

The pervasiveness of this “rose-tinted glasses” view leading to over-optimistic assessments was demonstrated by Neil Weinstein of University of Arizona.
He investigated people’s beliefs about future positive and negative health events, discussed in a previous blog post.
Weinstein reported that people tend to believe negative events are less likely to happen to them than to others, whereas they expect they are more likely than other people to experience positive events.

Hilary’s team built on Hackbarth’s concepts by comparing North American companies’ quarterly earnings forecasts with analysts’ predictions and actual performance.
Then, they calculated the number of company-issued press releases containing optimistic language.

Optimistic performance forecasts were correlated with better-than-expected performance, suggesting that successes led to additional effort and positive expectations.

Hilary noted the potentiating effect of past successful performance, though it may lead to “burnout” after about four quarters due to the challenge of continually exceeding performance expectations.

The team noted that this cycle of over-optimism and burnout might be mitigated by instituting policies to moderate overestimates or underestimates future performance by rewarding executives who provide accurate forecasts.

Sheryl Winston Smith

Sheryl Winston Smith

Similarly, Temple’s Sheryl Winston Smith noted that optimistic entrepreneurs chose higher levels of debt financing relative to equity, facilitating patent-based and product-based innovation among nearly 5,000 US firms tracked by the Kauffman Firm Survey (KFS).

Young-Hoon Kim

Young-Hoon Kim

In contrast to these financial studies, Yonsei University’s Young-Hoon Kim, Nanyang Technical University’s Chi-yue Chiu and Zhimin Zou of University of Illinois reported mixed results for self-enhancing (overconfident) and self-effacing (pessimistic) biases on performance

Chiu Chi-Yue

Chiu Chi-Yue

Kim’s team posited that either over-optimistic or pessimistic biases lead to “self-handicapping” behavior, in which people perform under disadvantageous conditions that provide an explanation for any poor performance outcomes.

Although over-optimism may drive innovation and financial results, longer-term consequences may include performance “burnout,” reduced motivation, and lower performance.

-*How to you manage the impact of optimism bias and pessimism bias on judgments and performance?

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