Overconfidence Ensures Failure in Business

Smug people make lousy entrepreneurs.

New research reveals big-headed business people are more likely to jump into new ventures with little regard for competition and market size. The results, detailed in the recent issue of the journal Experimental Psychology, shed light on why many ventures fail in the first few years.

In 2006, nearly 650,000 new businesses with employees opened their doors in the United States, while nearly 565,000 firms closed, according to the U.S. Small Business Administration. More than 99 percent of the nearly 27 million businesses in the U.S. in 2006 were small firms with fewer than 500 employees.

"Market entry decisions tend to be overoptimistic," said lead researcher Briony Pulford, a psychologist at the University of Leicester in England, "with the inevitable result that new business startups tend to exceed market capacity, and many new businesses fail within a few years."

Pulford and her colleagues set up a game that simulated market conditions. Participants stood to gain capital or see a loss based on their decisions on whether to open restaurants given different market scenarios.

"Our results showed that when success depended on skill, overconfidence tended to cause excess entry into a market place," Pulford said.

The self-sure participants tended to venture into markets that were too small to accommodate another profitable business. "Excess entry was much more frequent when market capacity was small," Pulford said, "suggesting that entrepreneurs do not take sufficient account of market capacity."

The individuals most likely to make overoptimistic decisions were those with absolute confidence in their own abilities. So the cockiness didn't arise from comparisons with others.

Some advice for eager entrepreneurs: "They should beware of overconfidence," Pulford said, "and they should be especially wary when entering small markets or markets that seem to present easy business opportunities, because over-entry seems most likely in these circumstances."

Funding for the study came from the Economic and Social Research Council.