Quick Insight
People underestimate the odds of being wrong. They underestimate the volatility of outcomes. The answer to overconfidence may be a simple formula. The accuracy of experts in “low validity environments” (decisions where there is a high degree of uncertainty or unpredictability) is consistently matched or exceeded by a simple formula.
Relative to other people, how would you rate yourself as a driver?
- Above average?
- Average?
- Below average?
82% of a group of students rated themselves in the top 30% with the highest driving safety record. Most of us think we’re above average. But that’s impossible.
People underestimate the odds of being wrong. They underestimate volatility of outcomes. Events they deem “impossible” happen. This causes us to be unprepared for extreme outcomes – “black swans”
In addition, overconfidence increases:
- As our forecast horizon increases
- With the difficulty of the question we’re answering
- As our amount of information increases
Let’s look see how this plays out for overconfident CEOs. They are more likely to:
- Engage in value-destroying mergers.
- See their stock as undervalued so they rely on debt too much as a source of funding.
- Use long-term debt instead of short-term debt
- Use lower discount rates to value cash flows
- Invest more – potentially stressing liquidity
The answer to overconfidence may be a simple formula. Human decision makers are inferior at predictions than a formula – even when we are given the results of the formula.
The accuracy of experts in “low validity environments” (decisions where there is a high degree of uncertainty or unpredictability) is consistently matched or exceeded by a simple algorithm.
In these situations, try to focus on the simplest, most objective set of facts you can gather on the situation. What are the key indicators of past success in similar situations? Have everyone rate the solution on those key objective predictors of success. Run a much wider set of scenarios than you think necessary and spend more time looking at the full range of outcomes.
I wish you humility in the face of uncertainty. I wish you well.
- Rob Stephens
Further Insight
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