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The Curse of Overconfidence
 

A little bit of self-assuredness goes a long way. Too much, and you're likely to put your capital at risk, according to a recent study.

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You can't talk about being an entrepreneur without recognizing the need for confidence. Doing things no one else has tried while friends, relatives, and acquaintances wonder whether you need meds more than capital requires a healthy dose of ego and self-assuredness.

But even as confidence is important, you can fall into deep trouble when it runs away from you. A recent study by researchers at University of Missouri, Georgia Tech University, and the University of Texas-Arlington suggests that overconfident CEOs make riskier choices and can put their access to capital in danger.

Overconfidence and M&As

According to Stephen Ferris, professor of finance at the University of Missouri and one of the researchers, CEOs who are overconfident make risky choices. For example, when looking for acquisitions, they may choose companies that aren't focused on the same core business. As Ferris says in a university press release, "Generally speaking, mergers that diversify companies don't work."

The study looked at M&A activity. Another result was that overconfident CEOs would often use cash to purchase other companies. Why? The CEOs thought that their companies' stocks were undervalued. So they saved the stock, even though paying cash drains a resource important for operational continuity as well as growth.

So, where does this overconfidence come from? According to the study, countries that focus on individualistic characteristics rather than "long-term orientation" are more likely to produce overconfident CEOs. Among the individualistic countries were the U.S., France, Germany, and the U.K.

If you think about it, this should hardly be a startling conclusion. People are confident when they believe they can make things work out, even in the face of adversity. The more confident the individual, the more the person assumes that overcoming barriers and unforeseen circumstances is possible and even likely.

Avoiding the Overconfidence Curse

Although the study was focused on investors who don't want to lose their money, the suggested solutions are just as important to the entrepreneur who wants to make a business work. Here are three questions that the study suggests investors ask:

  • "Who is looking over the CEO's shoulder and determining if decisions are being made too fast?"
  • "Is the board asking good questions before major decisions are made?"
  • "Does the CEO follow the board's direction or make decisions without any consultation with board members?"

They point to the importance of a board that is more than investors. You need expert advice and insight from people who sincerely want to see you succeed. Choose board members who will encourage your questions, and who will ask tough questions of you.

Also important is to develop a truly questioning mind and the ability to analyze whether your choices actually are the best. The idea is not to paralyze yourself and your business, but to make yourself think critically about your plans, strategies, and choices.

IMAGE: Shutterstock
Last updated: Jul 18, 2013

ERIK SHERMAN's work has appeared in such publications as The Wall Street Journal, The New York Times Magazine, and Fortune. He also blogs for CBS MoneyWatch.
@ErikSherman




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