Overconfidence and risk dispersion

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.

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