Optimistic Overconfidence in Business Forecasting
The cited studies describe overly optimistic business forecasts and poorly calibrated probability judgments. These are related problems: optimism favors desirable outcomes, while overconfidence assigns more certainty than the evidence supports.
THE IDEA
Calibration in Business Settings
The cited review discusses optimistic overconfidence in business, including attention to desirable outcomes (Kahneman & Lovallo, 1993; Kahneman & Tversky, 1995). It reports these findings:
- Financial Forecasts: Wall Street analysts expected S&P 500 earnings growth of 21.9% per year from 1982 to 1997, but actual growth averaged only 7.6% (Cadsby, 2000).
- Production Estimates: A survey of OECD firms showed systematic over-optimism in production estimates, with a bias toward seeking confirming evidence (Madsen, 1994).
- Negotiation: Studies by Bazerman and colleagues found that negotiators overestimate the probability their final offer will be accepted and that a third party will rule in their favor (Bazerman & Neale, 1982; Neale & Bazerman, 1983; Farber & Bazerman, 1986, 1989).
- Entrepreneurs: A survey of 3,000 new business owners revealed unrealistic optimism: 81% probability of success for their own business vs. 59% for similar businesses, while realistic rates range from 30% to 70% (Cooper, Woo, & Dunkelberg, 1988).
- Economic Forecasters: Calibration of economists’ recession forecasts worsened with longer time horizons (Braun & Yaniv, 1992). They showed overextremity, and at horizons of four quarters, their models had no discriminatory power, yet judgments remained extreme.
- Stock Market: Odean (1998) found overtrading due to overconfidence; purchased stocks underperformed sold stocks. In a Turkish stock market study, brokers showed poor calibration, especially over longer intervals (Onkal & Muradoglu, 1994).
These examples give reasons to compare forecasts with base rates, record outcomes, and check whether stated confidence matches observed accuracy.
When to use it
When making financial projections for a startup, use historical base rates for similar businesses to temper optimism.
In a negotiation, estimate the likelihood of your offer being accepted by consulting data on similar negotiations.
When evaluating economic forecasts, consider the forecaster's track record and adjust for overconfidence in longer-term predictions.
When making hiring decisions, avoid overestimating the success of a candidate; use base rate information on role performance.
FROM THEORY TO EVERYDAY LIFE
In practice
Wall Street Earnings Forecasts
From 1982 to 1997, analysts expected S&P 500 earnings growth of 21.9% per year but actual growth was only 7.6%.
Entrepreneurial Optimism
The cited survey reports an 81% estimated success probability for owners’ own businesses versus 59% for similar businesses. The review compares these with success rates ranging from 30% to 70%; evaluating that comparison also requires a consistent definition of success and time horizon.
Economists' Recession Calibration
The review reports that recession forecasts became less well calibrated at longer horizons. Overextremity means probabilities were too close to certainty or impossibility relative to observed outcomes; it does not mean only that recessions were predicted too often.
A MOMENT TO REFLECT
Put it to work.
How can you adjust your forecasts to account for the optimism bias demonstrated in business settings?
What strategies can improve calibration of probability judgments over long time horizons?
In what ways might overconfidence lead to suboptimal outcomes in negotiations or investment decisions?
References
- Kahneman & Lovallo (1993) — Kahneman, D. & Lovallo, D. (1993)
- Kahneman & Tversky (1995) — Kahneman, D. & Tversky, A. (1995)
- Hogarth & Makridakis (1981) — Hogarth, R. M. & Makridakis, S. (1981)
- Cadsby (2000) — Cadsby, C. B. (2000)
- Cooper, Woo, & Dunkelberg (1988) — Cooper, A. C., Woo, C. Y., & Dunkelberg, W. C. (1988)
- Braun & Yaniv (1992) — Braun, P. A. & Yaniv, I. (1992)
CONTINUE THE CONVERSATION
Source texts
- Heuristics and Biases The Psychology of Intuitive Judgment (Thomas Gilovich, Dale Griffin, Daniel Kahneman)