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Курсовик The Impact of Overconfidence and Optimism Bias on Strategic Decision Making
Тип работы: Курсовик.
Предмет: Ин. языки.
Уникальность по antiplagiat.ru: < 30%
1. Introduction 2
1.1 Approach 2
1.2 Classification of Overconfidence and Optimism Bias 2
2. Overconfidence Bias 3
2.1 Definition of Overconfidence Bias 3
2.1.1 General Definition 3
2.1.2 Business Definition 3
2.1.3 Forms of Overconfidence Bias 4
2.2 Factors fostering Overconfidence Bias 4
2.2.1 Why Overconfidence Bias occurs 4
2.2.2 Overview of possible influencing Factors 5
2.2.3 Difficulties avoiding Overconfidence Bias 8
2.3 Measuring Overconfidence Bias 8
2.4 Benefits of Overconfidence Bias 9
2.5 Drawbacks of Overconfidence Bias Overestimation of Accuracy 10
2.6 Outcomes of Overconfidence Bias 11
2.7 Examples of Overconfidence Bias 12
2.7.1 Execution of job interviews of BOS 12
2.7.2 Leisure Park N?rburgring 13
2.8 Recommendations for Overconfidence Bias 15
3. Optimism Bias 16
3.1 Definition of Optimism Bias 16
3.1.1 General Definition of Optimism Bias 16
3.1.2 Business Definition of Optimism Bias 17
3.2 Factors fostering Optimism 18
3.3 Measuring Optimism Bias 19
3.4 Optimism Bias as a Double-edged Sword 20
3.4.1 Benefits of Optimism Bias 20
3.4.2 Drawbacks of Optimism Bias 20
3.5 Outcomes of Optimism Bias 21
3.6 Examples of Optimism Bias 22
3.6.1 Groupon Inc. 22
3.6.2 Diehl Aircabin GmbH 23
3.7 Recommendations for Optimism Bias 24
4. Comparison of the Optimism and Overconfidence Bias 25
5. Conclusion 26
6. References 27
Nowadays, managers have to make decisions on a daily basis. Many decisions are affected by different characteristics of a manager’s personality. Thus, different kinds of cognitive biases can occur. The overconfidence and optimism bias are considered to be biases of this category. Both can have a bad influence on business decisions (Weber & Sch?fer 2011, p. 263). Overconfidence is a bias which has been already analyzed by several well-known philosophers like Confucius and Socrates a long time ago. The following quotation indicates, that overconfidence is a cognitive bias which is no discovery from this day and age (Russo & Schoemaker 1992, p. 7). “To know that we know what we know, and that we do not know what we do not know, that is true knowledge” (Russo & Schoemaker 1992, p. 7). Theses philosophers wanted to create a better comprehension of the cognitive bias overconfidence. They already realized difficulty to find the right balance between realism and confidence. The optimism bias is also a well-known phenomenon. Some people seem to wear rose-colored glasses and have an overoptimistic attitude regarding future developments of business.
The following paper gives a short overview of the overconfidence and the optimism bias. The first part of the paper includes a description, factors which are fostering the biases and several possibilities to measure the extent of the biases. The second part of the paper describes the possible benefits, drawbacks and outcomes for each bias. Finally, the extent of possible outcomes is illustrated through given practical examples and appropriate recommendations for preventing the examples to occur. Furthermore, general recommendations avoiding the two biases are outlined and a final conclusion is given.
1.2 Classification of Overconfidence and Optimism Bias
For many recent years, psychologists studied human behavior and the factors influencing the adoption of a decision. The last few decades, economists tried to apply the acquired knowledge to practical cases in business environments. In many cases, heuristics and biases do not allow managers to make rational decisions in spite of all their efforts (Montier 2007, p. 19). This incident is caused by the fact that “most human choice is not made deliberately and consciously by weighting up and evaluating all the possible variations and permutations” (Gordon 2011, p. 173). In fact, mankind decides under the influence of “inherent biases built into our brains and bodies” (Gordon 2011, p. 173). People are constantly exposed to biases, most of them appear identical regardless to cultural or national characteristics (Montier 2007, p. 19). Hirschleifer (2001) specified four general causes that prompt errors in human behavior: self-deception, heuristic simplification, emotion and social interaction. Based on this hypothesis, Montier (2007, p. 20) proposed a classification of the basic biases. Overconfidence bias and Optimism bias belong to the category of self-deception.
2. Overconfidence Bias
2.1 Definition of Overconfidence Bias
2.1.1 General Definition
In 1992, Mahajan defined overconfidence as “an overestimation of the "correctness" of a set of predictions” (Mahajan 1992, p. 330). This means that people tend to think that their predictions will occur. Bhandari and Deaves developed a more specific definition of overconfidence. They defined it as “the tendency for people to overestimate their knowledge, abilities and the precision of their information” (Bhandari & Deaves 2006, p. 5). In 2010, Deaves and Ackert enlarged this definition (2010, p. 106): “Overconfidence is the tendency for people to overestimate their knowledge, abilities and the precision of their information, or to be overly sanguine of the future and their ability to control it.” In other words, people tend to be too certain in the precision of their future predictions. As they receive more information about the case, the accuracy or their judgments may not increase, but their confidence will. People are convinced that they have sufficient knowledge to solve complicated problems.
2.1.2 Business Definition
In 1969, for the first time overconfidence has been described by Alpert and Raiffa and in accordance with Bazerman and Moore (2009) can consist of two appearances. “The first is the tendency of individuals to express excessive belief in their own capacity” (Cesarini, et al. 2006, p. 454). Managers, who are too confident in their competence, may not be susceptible to the apprehension of alternative views or new arguments. Other authors of literature show how managers can become over overoptimistic expectations about outcomes due to differences in the way of estimation or interpretation of knowledge and information (Hilton, Regner, Cabantous, Charalambides & Vautier 2011). The Financial Times dictionary provides a business definition: “Overconfidence in business or trading, an overestimation of ones abilities and of the precision of ones forecasts. Overconfident managers set overly narrow confidence intervals in making predictions” (The Financial Times Ltd 2013) They have to take overconfidence into consideration, otherwise it could lead to problems in the business sector, for instance destroying company value or losing market share and profit.
2.1.3 Forms of Overconfidence Bias
Moore and van Zant categorize three different forms of overconfidence. The first dimension is overestimation, which means that people tend to think that they are better than they actually are. The second one is overplacement and can be defined as the fact that people think that they are better than others even if they are not (van Zant & Moore 2013, p. 7). This phenomena is also called the “better-than-average effect” as people think that their knowledge and abilities are above-average (Ackert & Deaves 2010, p. 110). The third form of overconfidence is known as overprecision, which means that people are too sure to know the truth (van Zant & Moore 2013, p. 7). Ackert and Deaves (2010, p. 106) name this form miscalibration. They also identify two further forms of overconfidence, illusion of control and excessive optimism (Ackert & Deaves 2010, pp. 110 ff.) Illusion of control is defined as an expectancy of a personal success probability inappropriately higher than the objective probability would warrant (Langner 1975, p. 313). “Excessive optimism reflects the feeling that things will be rosier than objective analysis suggests” (Ackert & Deaves 2010, p. 110). It is equal to the overoptimism bias and is therefore explained in detail later on.
2.2 Factors fostering Overconfidence Bias
2.2.1 Why Overconfidence Bias occurs
The reason why the overconfidence effect occurs is that people have a limited understanding of their own knowledge. In general, knowledge is defined as the summary of all facts, theories, relationships and concepts that a person has accumulated over time. However, metaknowledge goes beyond the mentioned and described knowledge and it is difficult for humans to get aware of it. It includes the understanding of the nature and scope as well as the limits of a person’s primary knowledge. Furthermore, it contains the uncertainty of a person’s predictions and estimations and the ambiguity inherent in premises and world views. Therefore, overconfidence can be reduced, when people recognize the limits of their primary knowledge and ask for more or further information. However, Russo and Schoemaker found out that even experts are often unable to say how much they are unaware of their specialized topic. In business, this uncertainty about the unknown knowledge leads to underestimating risks, missing deadlines or overrunning budgets (Russo & Schoemaker 1992, pp. 8 f.).
Furthermore, the illusion of knowledge can affect people’s confidence in the accuracy of their decisions. This is a perilously misconception, since they believe that more information improves precision of forecasts. According to Daniel Boorstin’s opinion: “The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge”. It does not matter how much information a person possesses, but how it will be used, because in reality “more information is not necessarily better information” (Montier 2007, p. 20). Research by Torngren and Montgomery (2004) shows that professional investors are more often overconfident in the field of investment. The study involved two groups - experts (portfolio managers, analyst, and brokers) and non-experts (psychology students). Participants were required to predict the most successful investments in stocks given the information about the firm and the history of changes in stock prices over the past twelve months. In addition to this, they had to evaluate the confidence of each of their forecasts. As a result, the laity predictions showed greater profits. It is noteworthy, that accuracy of professionals was lower than fifteen percent, when they were 100 percent sure of the correctness of the choice. Forecasts of the lay people increasingly based on an analysis of the previous periods prices, while professionals used their expertise (Torngren & Montgomery 2004).
2.2.2 Overview of possible influencing Factors
The overconfidence bias is basically an effect which can occur independent of social level, age, gender and education of each individual and in different kinds of situations. However, several studies found out, that particular factors can foster the overconfidence bias. Therefore, it is really important for managers to be aware of these factors. The awareness of fostering factors can lead to a better understanding of the own self-assessment and the self-assessment of others in strategic decision-making processes.
Several studies of overconfidence demonstrate, that men tend to be more overconfident than women. A study which was published in the economic letters in 2011, showed that this tendency already occurs among young people. The test results of the survey showed, that tested male students tend to be overconfident and female students tend to be even under-confident regarding to their personal performance (Dahlbom et al. 2011, p. 325). Another survey from Brad M. Barber and Terrance Odean showed, that both genders can act overconfident regarding to financial trade. But the results demonstrated, that men have a higher tendency of overconfidence than women (Barber & Odean 1999, p.51).
The study “Age Differences in the Realism of Confidence Judgments” found a positive correlation between the age of the tested persons and their tendency of overconfidence. They tested persons in different ages in regard to their confidence judgments. The elderly tested persons showed a greater tendency to be overconfident than the younger test persons (Crawford J D & Stankov L 1996, p. 99).
Generally we could assume, that well-educated people tend to make better decisions because of their knowledge and their approach to solve difficult issues. A study in Canada found out that well-educated people are much more confident than less educated people regarding to their investment knowledge. Furthermore they found out, that the well-educated people were more overconfident. That means, that the gap of their self-assessment regarding their investment knowledge and their actual knowledge were greater (Bhandari, G & Deaves, R 2006, p. 5-11).
Fields of Expertise
Several studies have shown that a lot of people are acting overconfident in their area of expertise. This overestimation of the own capabilities was shown in different business professions. If persons deal with a specific topic regularly, they feel much more confident and might be acting more automatically. This effect can lead to lower attention, less information and finally to wrong decision-making (Ackert & Deaves 2010, p. 112; Barber & Odean 1999, p. 47).
Several surveys showed, that analyzed subjects acted especially overconfident in difficult and complex situations with a low prediction accuracy. This phenomenon was noticed in areas, for instance the shares market, in which it is very difficult to make any predictions of the future (Fischhoff, Slovic & Lichtenstein 1977, p. 561 ff.). Furthermore, another study found out, that the degree of overconfidence regarding decisions in the area of the stock market is higher than regarding decisions in other areas (Barber & Odean 2002).
Gearvais and Odeon using their model of overconfidence showed, that the overconfidence bias is dynamic. The degree of overconfidence depends on past ........
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