Ann Arbor: Studying events like the 2008 financial crisis in hindsight leads many to ask, "How could they have gotten it so wrong?" New research by University of Michigan professor Martin Schmalz finds
that overconfidence—underestimating risks—can be a rational response to
fear, or "anxiety," but the balance between the two can fluctuate over
time. "So many CFOs were overconfident before the financial crisis and
underestimated risk. That's quite puzzing" said Schmalz, assistant
professor of finance at U-M's Ross School of Business. "Given they are
the experts, why were they still so bad at it?"
His study, "Anxiety, Overconfidence, and Excessive Risk Taking," with
Thomas Eisenbach of the Federal Reserve Bank of New York, indicates
that there's a balance between overconfidence and fear that can get out
of whack during times of robust profits or market crashes.
Given the human tendency to be overly afraid of near-term risks,
overconfidence is necessary for profits and innovation, Schmalz said. If
nobody took chances, few things of value would be created.
People know they will be nervous before making a risky move, he said.
So they signal the move to others, which helps prevent them from
backtracking or "chickening out." They also tend to ignore negative
opinions or facts about what they're about to do.
This variation in confidence levels over time can explain why
otherwise rational people missed risk that in hindsight looks obvious
and amplifies bubbles, and why everyone acts timid after a market crash
when the risks are lower, he said.
"A moderate amount of overconfidence is just at the sweet spot
counteracting our irrational fears," Schmalz said. "That's something
that can help economists understand the role human nature plays in the
market."