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Overconfidence and risk dispersion

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  • Heller, Yuval

Abstract

Experimental evidence suggests that people tend to be overconfident in the sense that they overestimate the accuracy of their own predictions. In this paper we present a simple principal-agent model in which principal's interest in dispersing risk motivates him to hire overconfident agents. We show that the induced overconfidence satisfies experimental stylized facts (such as, hard-easy effect, false certainty effect and underuse of base rates). In addition, we show that overconfidence is a unique stable evolutionary strategy, and that it can Pareto-improve social welfare. Finally, we demonstrate applicability by: 1) demonstrating why CEOs hire overconfident intermediate managers, and 2) explaining why investors prefer overconfident entrepreneurs.

Suggested Citation

  • Heller, Yuval, 2010. "Overconfidence and risk dispersion," MPRA Paper 25893, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:25893
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    References listed on IDEAS

    as
    1. Gervais, Simon & Odean, Terrance, 2001. "Learning to be Overconfident," Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 1-27.
    2. Bruce A. Weinberg, 2009. "A Model Of Overconfidence," Pacific Economic Review, Wiley Blackwell, vol. 14(4), pages 502-515, October.
    3. Robson, Arthur J., 1996. "A Biological Basis for Expected and Non-expected Utility," Journal of Economic Theory, Elsevier, vol. 68(2), pages 397-424, February.
    4. Skala, Dorota, 2008. "Overconfidence in Psychology and Finance – an Interdisciplinary Literature Review," MPRA Paper 26386, University Library of Munich, Germany.
    5. David V. Budescu & Ning Du, 2007. "Coherence and Consistency of Investors' Probability Judgments," Management Science, INFORMS, vol. 53(11), pages 1731-1744, November.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Frenkel, Sivan & Heller, Yuval & Teper, Roee, 2012. "Endowment as a blessing," MPRA Paper 39430, University Library of Munich, Germany, revised 30 Apr 2012.

    More about this item

    Keywords

    overconfidence; risk dispersion; hard-easy effect; evolutionary stability;

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games

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