Entrepreneurial Delusions

ENTREPRENEURIAL DELUSIONS

The research cited in this account puts the chances that a small business will survive for five years in the United States at about 35%. But the individuals who open such businesses do not believe that the statistics apply to them. A survey found that American entrepreneurs tend to believe they are in a promising line of business: their average estimate of the chances of success for "any business like yours" was 60%—almost double the true value. The bias was more glaring when people assessed the odds of their own venture. Fully 81% of the entrepreneurs put their personal odds of success at 7 out of 10 or higher, and 33% said their chance of failing was zero.

The direction of the bias is not surprising. If you interviewed someone who recently opened an Italian restaurant, you would not expect her to have underestimated her prospects for success or to have a poor view of her ability as a restaurateur. But you must wonder: Would she still have invested money and time if she had made a reasonable effort to learn the odds—or, if she did learn the odds (60% of new restaurants are out of business after three years), paid attention to them? The idea of adopting the outside view probably didn’t occur to her.

One of the benefits of an optimistic temperament is that it encourages persistence in the face of obstacles. But persistence can be costly. An impressive series of studies by Thomas Åstebro sheds light on what happens when optimists receive bad news. He drew his data from a Canadian organization—the Inventor’s Assistance Program—which collects a small fee to provide inventors with an objective assessment of the commercial prospects of their idea. The evaluations rely on careful ratings of each invention on 37 criteria, including need for the product, cost of production, and estimated trend of demand. The analysts summarize their ratings by a letter grade, where D and E predict failure—a prediction made for over 70% of the inventions they review. The forecasts of failure are remarkably accurate: only 5 of 411 projects that were given the lowest grade reached commercialization, and none was successful.

Discouraging news led about half of the inventors to quit after receiving a grade that unequivocally predicted failure. However, 47% of them continued development efforts even after being told that their project was hopeless, and on average these persistent (or obstinate) individuals doubled their initial losses before giving up. Significantly, persistence after discouraging advice was relatively common among inventors who had a high score on a personality measure of optimism—on which inventors generally scored higher than the general population. Overall, the return on private invention was small, "lower than the return on private equity and on high-risk securities." More generally, the financial benefits of self-employment are mediocre: given the same qualifications, people achieve higher average returns by selling their skills to employers than by setting out on their own. The evidence suggests that optimism is widespread, stubborn, and costly.

Psychologists have confirmed that most people genuinely believe that they are superior to most others on most desirable traits—they are willing to bet small amounts of money on these beliefs in the laboratory. In the market, of course, beliefs in one’s superiority have significant consequences. Leaders of large businesses sometimes make huge bets in expensive mergers and acquisitions, acting on the mistaken belief that they can manage the assets of another company better than its current owners do. The stock market commonly responds by downgrading the value of the acquiring firm, because experience has shown that efforts to integrate large firms fail more often than they succeed. The misguided acquisitions have been explained by a "hubris hypothesis": the executives of the acquiring firm are simply less competent than they think they are.

The economists Ulrike Malmendier and Geoffrey Tate identified optimistic CEOs by the amount of company stock that they owned personally and observed that highly optimistic leaders took excessive risks. They assumed debt rather than issue equity and were more likely than others to "overpay for target companies and undertake value-destroying mergers." Remarkably, the stock of the acquiring company suffered substantially more in mergers if the CEO was overly optimistic by the authors’ measure. The market response was consistent with the researchers’ concern about CEO overconfidence. This observation exonerates the CEOs from one accusation even as it convicts them of another: the leaders of enterprises who make unsound bets do not do so because they are betting with other people’s money. On the contrary, they take greater risks when they personally have more at stake. The damage caused by overconfident CEOs is compounded when the business press anoints them as celebrities; the evidence indicates that prestigious press awards to the CEO are costly to stockholders. The authors write, "We find that firms with award-winning CEOs subsequently underperform, in terms both of stock and of operating performance. At the same time, CEO compensation increases, CEOs spend more time on activities outside the company such as writing books and sitting on outside boards, and they are more likely to engage in earnings management."

Many years ago, my wife and I were on vacation on Vancouver Island, looking for a place to stay. We found an attractive but deserted motel on a little-traveled road in the middle of a forest. The owners were a charming young couple who needed little prompting to tell us their story. They had been schoolteachers in the province of Alberta; they had decided to change their life and used their life savings to buy this motel, which had been built a dozen years earlier. They told us without irony or self-consciousness that they had been able to buy it cheap, "because six or seven previous owners had failed to make a go of it." They also told us about plans to seek a loan to make the establishment more attractive by building a restaurant next to it. They felt no need to explain why they expected to succeed where six or seven others had failed. A common thread of boldness and optimism links businesspeople, from motel owners to superstar CEOs.

The optimistic risk taking of entrepreneurs surely contributes to the economic dynamism of a capitalistic society, even if most risk takers end up disappointed. However, Marta Coelho of the London School of Economics has pointed out the difficult policy issues that arise when founders of small businesses ask the government to support them in decisions that are most likely to end badly. Should the government provide loans to would-be entrepreneurs who probably will bankrupt themselves in a few years? Many behavioral economists are comfortable with the "libertarian paternalistic" procedures that help people increase their savings rate beyond what they would do on their own. The question of whether and how government should support small business does not have an equally satisfying answer.