Executive Summary
While entrepreneurs are often renowned and celebrated for their willingness to take risks – to the point that encouraging someone to “be more entrepreneurial” is an analogy for taking more risks – the reality is that research shows entrepreneurs often consider themselves otherwise. From the entrepreneur’s perspective, though, what they do doesn’t necessarily seem risky – at least to themselves – because of the confidence they have in their own abilities (i.e., a belief that they will be able to navigate whatever challenges arise). Yet if entrepreneurs aren’t actually necessarily risk-takers – just very confident, or perhaps even overconfident – the question arises: what’s the best way to counsel an entrepreneur through the risks of their financial decisions if they don’t recognize those risks in the first place?
The large scope of what it actually means to be an ‘entrepreneur’ (e.g., from a goat farmer in a tiny third-world-country village to a solo divorce attorney in a large metropolitan city), and the variability in risk tolerance measurement methodologies that are used to evaluate them, makes it difficult to definitively substantiate the idea that entrepreneurs, by nature, are high-risk seekers. As some studies suggest, entrepreneurs do not necessarily take on more risk than non-entrepreneurs; rather, they may simply have a relatively high confidence (often to the point of overconfidence) level in their own capabilities… such that they don’t perceive what they’re doing to be risky in the first place. For financial advisors, this means that for some of their clients who are business owners (and for some advisors themselves!), the challenge may not be so much about dealing with high risk-takers, but instead about how to work with clients who can be overconfident (and fail to recognize the risks they actually are taking).
In turn, there are three aspects of overconfidence: overestimation (when someone believes they are better at something they actually are), overplacement (when someone believes they are better than a targeted person or group, even though they are not), and overprecision (when someone believes their expertise or ability is based on facts or past experiences, but the facts and/or experiences have been incorrectly recalled). And while exaggeration of any of these facets of overconfidence can lead to potentially disastrous results, attenuating the overexpression of these behaviors can actually be beneficial for individuals facing difficult challenges.
Financial advisors can help overconfident clients by ensuring their clients understand their financial situation clearly and accurately. This reduces the risk of clients taking action on wrong information, and can help ensure that the client has a clear understanding of ‘normal’ parameters pertinent to their financial situation, whether that relates to a business venture or simply a personal checking account balance.
Another tool that the advisor can use to help clients recalibrate potentially skewed (i.e., overconfident) beliefs they may have about their own abilities or resources is an adaptation of Subjective Probability Interval Estimates (SPIES), a methodology developed by psychology researchers to study overconfidence. By helping the client identify all possible outcomes of a decision being considered, advisors can help the client gain a clear, objective perspective of accurate and realistic information.
Ultimately, the key point is that financial advisors working with entrepreneurial clients shouldn’t necessarily assume that they are risk-takers, and instead recognize that their confidence (or overconfidence) may instead be blinding them to their risks. Yet at the same time, advisors with overconfident clients don’t necessarily need to encourage these clients to abandon their overconfidence (which really can help them to overcome the real-world daunting challenges of entrepreneurship). Instead, presenting clients with enough knowledge to help them understand how the actual risks they may be facing can impact their situation (and how those risks may pose very real threats to them, which can arise through the actions of other, potentially less skilled/knowledgeable individuals over whom the client has no control – no matter how lucky they may feel) can be the cornerstone for creating a sound financial plan, that still takes prudent risks… but with all the appropriate safeguards in place!
Do Entrepreneurs Really Seek More Risk?
Entrepreneurs are commonly thought to seek more risk than the average individual who chooses at least the ‘relative safety’ of a job at an established business that can provide an ongoing paycheck. And while it may be true that most entrepreneurs (like nearly all business managers) are required to take some degree of risk when they launch a venture from scratch in the hopes of turning it into a successful, self-sustaining organization, how exactly is risk-seeking behavior measured and what, if any, are the experimental controls being used? Not surprisingly, various studies indicate mixed results about whether entrepreneurs do actually seek to take more risk than the average person.
So how did this belief that entrepreneurs are more risk-tolerant arise? Original research by the Irish-French economist Richard Cantillon first presented entrepreneurs as risk-bearers and dates back to 1755. Later, American economist Frank Knight, in his book “Risk, Uncertainty and Profit” published in 1921, popularized the idea that entrepreneurs who bear uninsurable risk are rewarded with profit.
However, these long-standing ideas of entrepreneurs as risk-takers have been challenged by more recent empirical research, which paints a different picture of entrepreneurs, showing in study after study that there is little conclusive evidence that entrepreneurs are, by and large, more risk-seeking than the non-self-employed worker.
Meta-analyses examining the results from several studies have more recently addressed the issue with mixed results. While some of these meta-analyses have suggested that entrepreneurs are more risk-seeking, others have found that they are not. And while there may be no real consensus on the question of entrepreneurial risk-taking, it does turn out that there is also no real consensus on how to measure this seemingly simple question in the first place!
These seemingly contradictory mixed results appear primarily to be a result of how ‘risk tolerance’ is defined in the first place. Researchers in the meta-analyses point out that that there are many different scales, which makes it very hard to compare apples to apples (and they are not the only ones, financial planning researchers, not just economists, discuss the very same issue).
Other reasons for mixed results stem from the wide-ranging scope of what it means to be an “entrepreneur”. Just consider the differences in potential revenue, clientele base, and business opportunities available to a small business owner in a third-world country village versus one doing business in a densely populated metropolitan area, or a solo lawyer specializing in medical malpractice compared to a mechanic running his own auto-body shop; even within the domain of being “entrepreneurs”, these varying endeavors likely have very different risk profiles. Finally, some studies also measured behavioral factors like motivation for more money while others did not, and this too (what gets included in the study versus what is left out) impacts outcomes and interpretations.
Entrepreneurs May Not Necessarily Be High-Risk Seekers, They May Just Be Overconfident In Their Own Abilities
Given the seemingly contradictory (or at least confusing) results of these studies, new ideas about the motivational drivers of entrepreneurs have emerged. One leading thought is that entrepreneurs don’t necessarily seek out more risk; instead, their behaviors might instead be explained by overconfidence. In other words, entrepreneurs don’t necessarily seek risk any more than non-entrepreneurs, but they do perceive and, therefore, experience risk in a different way when compared to non-entrepreneurs. The fact that different individuals have different perceptions of the same risk is very common and well studied.
Essentially, the idea is that entrepreneurs often believe that they have the requisite knowledge and/or ability to overcome the odds they are facing, and because of this, they perceive that the associated risk is minimal. And there are studies to support this idea. For instance, in a worldwide study of entrepreneurs, subjects were seen to be relatively overconfident. This overconfidence was often a key factor in making the decision to give entrepreneurship a try in the first place. Again, we also see parallels to this in financial risk tolerance versus risk perception – investors who buy more stocks in bull markets are not necessarily becoming more risk-tolerant; they just no longer perceive the same level of risk in stocks that always seem to be going up.
Beyond just the distinction between risk tolerance and risk perception, though, researchers Brian Wu and Anne Marie Knott now suggest that ‘risk tolerance’ itself actually consists of two components: “demand uncertainty” and “ability uncertainty”. While demand uncertainty relates to the uncertainty of external economic and market conditions (similar to what risk tolerance is typically viewed as measuring), ability uncertainty relates to the uncertainty about one’s own personal ability to make the changes necessary to succeed, which is essentially an internal measure of self-confidence.
In this two-part demand- and ability-uncertainty model, it appears that entrepreneurs are generally just like everyone else when it comes to demand uncertainty, but very different in terms of ability uncertainty. When it comes to ability uncertainty, entrepreneurs seem to have much less ability uncertainty than non-entrepreneurs. Stated differently, entrepreneurs think that risk is risky as much as non-entrepreneurs, but they also believe that they have the ability to find a way to manage or reduce the risk or that the risk doesn’t really apply to them because they have qualities and knowledge that others lack, which will help them deal with and overcome the risk.
In fact, researchers Brian Wu and Anne Marie Knott found evidence that entrepreneurs often try to balance ability uncertainty with demand uncertainty. They found that risk-averse entrepreneurs (yes, there is such a thing!) were willing to bear the market risk when their perceived degree of ability (i.e., their self-confidence) was comparable to their perceived level of demand uncertainty (risk). Basically, if entrepreneurs perceived the demand uncertainty to exceed their ability uncertainty (i.e., there was more uncertainty in the market than they believed they had the ability to overcome), they would be much less likely to take on the risk. Conversely, if they had confidence that their ability was higher than the perceived risk, they tended to ‘act’ riskier.
Overconfidence Has Three Forms: Overestimation, Overplacement, And Overprecision
While this article has focused on entrepreneurs, overconfidence is actually ubiquitous and can apply to anyone. Daniel Kahneman, considered to be the father of behavioral economics, wrote about overconfidence in his book “Thinking Fast and Slow”, noting that it is the most common bias. For instance, from the book, the French are known to consider themselves as above-average lovers, and Americans are known to consider themselves as above-average drivers.
It is important to recognize that overconfidence actually has three distinct forms: overestimation, overplacement, and overprecision. Overestimation is when someone believes that they are better at something than they actually are (e.g., you believe that you are a better lover, driver, or stock picker than you really are). Overplacement is the exaggerated belief that you are better than a targeted person or group of others (e.g., you believe you are a better lover, driver, and stock picker than most others or those in a particular group X). And finally, overprecision is the excessive faith that you know the truth; in other words, overprecision comes into play when you are confident in what you believe to be the facts, even if the facts you believe in are not quite accurate (e.g., perhaps you believe, from your own recollection, that you are a better lover, driver, or stock picker, but you are being ‘overly precise’ based on your limited experiences because the actual facts that back up those beliefs would suggest otherwise!).
While each form of overconfidence is independent of the others, the different forms can show up together. For instance, it would not be unheard of for someone to believe they are a really great poker player when, in reality, they have average poker skills (overestimation); they likely also see themselves as better than other poker players at the table (overplacement). Here we see how overestimation and overplacement work together so that we end up with a very overconfident poker player.
What is more, these variations can interact with one another. For example, overestimation and overplacement swap places when it comes to hard or easy tasks. Research shows that, when faced with hard tasks, people tend to engage in overestimation and underplacement. For example, when a test or task was hard, people tend to believe that they performed better than they likely did by overestimating their score relative to the average, and also tend to believe that others have performed better than them (i.e., they generally think they did worse than others). Yet on tasks they perceive as easy tasks, there is a tendency to underestimate and overplace. For example, when the test or task was easy, people often think they have performed worse (i.e., they underestimate themselves compared to the average), but report that they still think they did better than others (i.e., they think they are better, or overplace themselves, in comparison to others).
In other words, people believe they are above average on easy tasks (because of the nature of ego, people like thinking of themselves as better than others) and below average on difficult tasks (people often believe that something is impossible and that quitting, justified through underplacement, feels safer than trying and failing – again, a natural human tendency driven by ego). Luckily, though, lots of research on overconfidence has found that although people are susceptible to overconfident tendencies, their perceptions can actually be attenuated or brought back to reality by obtaining accurate information about the performance of others (which is fortunate because telling people that they have an ego issue rarely results in a productive or positive conversation!).
Overprecision, on the other hand, does not necessarily interact with overestimation or overplacement. Instead, overprecision can be seen as an escalation of either of the first two and, unsurprisingly, tends to become more prevalent with age; as with increasing age, people believe they know more of the truth, based on their years of life experiences, and may become more stuck in believing certain things (even if they are supported by facts that are incorrectly remembered).
However, overconfidence – and these factors of overestimation, overplacement, and overprecision – is not necessarily something that should be avoided, as overconfidence can, at the right times, actually help us (and our clients!) live in the world. After all, few people would ever even try to start new businesses as entrepreneurs, or to seek a cure for cancer, without a certain level of overconfidence to be able to ignore (or ‘favorably’ misperceive) their odds?
How Relative Degrees Of Confidence (And Overconfidence) Can Affect Perceived Reality
Now, if at this point you are thinking, okay…confidence is good, sure. But how or why is overconfidence better? Or are they one and the same? Good question. The answer deals with the degree of overconfidence an individual has and the way their overconfidence influences their perceived reality.
Example 1:
Jane (confidence): I believe that I can run my own widget business because I helped my father run his business.
I went to school and studied business, and I have an MBA where I completed an internship with a small business focused on widgets.
Jane has a lot of reasons to be confident. Yet, she is not necessarily doing anything new or innovative. While it is brave to start a business, history shows the odds for long-term success are generally not in the business owner’s favor. However, Jane’s ‘confidence’ is very measured and, in a way, relatively safe. Jane is neither overestimating nor overplacing.
Jim (overconfidence): I believe that I can run my own widget business because I see the widgets in a new light, given my experience.
I went to business school and did better than my fellow students. As a former employee of a father-son widget factory, I suggested a new protocol that I am confident would have worked better, even though it was not implemented because the owner never wanted to re-engineer their processes.
Here, Jim also has reasons to be confident, but his confidence has transcended into overconfidence in the way that he views himself in relation to the other widget-makers and the risk (although he doesn’t see it that way) of re-engineering of widgets.
For most people living normal lives, it would be really weird (and very difficult) to walk around believing you know nothing (except, perhaps, if you are a graduate student!). We need to believe that we know something in order to have any reasonable confidence to make day-to-day decisions and move through life productively. Consider the fact that most self-help books, as well as many articles on this website (and basically all of the Financial Advisor Success podcast episodes!), are about how to get more confidence.
And if that isn’t enough, consider the fact that much of the research discussed in this article suggests that without at least some overconfidence, there would probably be far fewer business owners and financial planners, as the financial services industry has long struggled with the fact that more than 70% of new recruits leave the industry in 3-5 years and that many financial advisors have acknowledged that they wouldn’t have chosen their profession had they not been overconfident in their ability and played against those odds.
Overconfidence, to a certain extent, is something that we absolutely need. We don’t want to kill it; we just want to attenuate it to our advantage.
How Financial Advisors Can Help Clients Benefit From Overconfidence
Given the advantages that research has shown overconfidence can have (at least when used ‘properly’) for business owners (including financial advisors who themselves run their own firms!), it is important to understand how advisors can leverage it to their (and their clients') advantage by recognizing how to balance what’s helpful about being overconfident with its potential dangers. For example, someone who believes they are a better driver might benefit by starting up a limousine business but should be cautious not to opt out of purchasing car insurance on that expensive car!
One strategy that advisors can adopt is to challenge a client’s (overconfident) beliefs under the guise of education or knowledge, especially when it comes to overestimation or overplacement that might lead to otherwise self-harming decisions. In essence, it is good to encourage clients to believe that they are capable, but even though it may be true that they possess certain skills or attitudes that set them apart, advisors can temper the encouragement they give to clients so as to prevent reckless behavior. For example, just because a client might believe they are an excellent driver, they should not be encouraged to skip car insurance or continue driving without a seatbelt – this would be silly and irresponsible when considering the mortality rates of people in car accidents who were not wearing seat belts.
By pointing out facts to clients under the guise of education (versus an outright challenge of their beliefs, which won’t get you very far), advisors can avoid making their client feel that their belief in whatever they feel overconfident in is under attack but at the same time instill awareness of the potential threats posed by risk. For example, if a person was overconfident that they are a good driver, some actual facts about auto safety and seatbelt efficacy may give them food for thought about the advantages of wearing a seatbelt, despite their belief that, because they are such a good driver, a seatbelt is an unnecessary burden.
And what is more, advisors can actually use overplacement to their advantage. For example, if your client believes they are that good of a driver, this also means that other people are really bad drivers; and by agreeing with your client that others are bad at driving, you reinforce the importance of using seatbelts – not because the client isn’t a great driver (heck, they are great!), but because of all the other crazies out there that the client needs to protect themselves from.
For financial advisors who work with savvy business owners, this approach might mean taking more time to review the risks of ‘common’ or ‘average’ people – which we may agree the client is not – but that does not mean that we can’t plan for risky events that may be linked to other less responsible/capable individuals, just like good drivers being attentive to potential bad drivers on the road. Thus, when helping entrepreneurs plan to build their next venture, we must also be sure to tell them, “Yes, you still really need to buy insurance!” and have a contingency plan for when business isn’t booming after year three.
Another way to confront overestimation and overplacement is to set small goals and have a very detailed plan. For instance, once you have addressed or acknowledged your client’s issues (e.g., you must have insurance and/or contingency plans for cash flow), advisors can work together with their clients to incorporate addressing the issues into the client’s financial plan.
Oftentimes, overestimation and overplacement can be handled simply by slowing down and not glossing over the details. In his book, “Thinking Fast and Slow,” Daniel Kahneman suggests that we need to think more slowly about some of our ideas. Advisors can help facilitate slower thinking for clients simply by focusing on the details and integrating more data during meetings, framed as open discussions (not as a lecture!).
Example 2: Gemma is an entrepreneur and owns a very profitable law office. Recently, Gemma decided to expand and open another office in a different part of the state.
Toby, her financial planner, has been with her from the start. He began working with Gemma when she was a partner at a different law firm and was there to help her when she decided to go out on her own.
Toby is excited to help Gemma take on the next challenge of opening another office and knows that she has the skills to do it. However, Toby wants to ensure that things go smoothly with this endeavor. When Gemma decided to establish her first office, she and Toby severely under-budgeted the project because Gemma overestimated her ability to control costs and the associated expenses with opening a new office. Toby does not want Gemma to make that mistake again.
In preparation for their next meeting, Toby pulls together current and average operating expenses with similarly sized law firms in the new city. As Gemma and Toby walk through the numbers, Toby presents this information to Gemma framed as knowledge of potential costs to expect (instead of a warning of the prior launch running over budget) to help them develop a practical budget for the new office project.
At first, Gemma is a bit resistant. She appreciates the numbers, but she repeats that there is no way that she is going to run one of those law offices (e.g., Gemma is exhibiting overplacement, thinking once again that she can somehow do better than another average firm)!
Toby knows from the research discussed on the Kitces blog that the tendencies of overestimators and overplacers can be attenuated without insult simply by being presented with additional data, and so he is confident that Gemma will dial down expenses if needed to make their agreed-upon budget numbers work.
Toby continues to work slowly through the numbers with Gemma and does not let her skip the details. For instance, when they get to furnishing the new office, Toby had a budget item of $75,000. Gemma said there was no way she would ever spend that much and that his budget estimate was a crazy number. Toby agrees it is high (the goal is not to fight Gemma on her beliefs) but then shows Gemma how he came up with the number, even going so far as to get quotes from a local office supply store.
Throughout this process, Toby does not argue with Gemma; he is just providing her with the information she needs and ensuring that she fully understands it, not letting her gloss over important (and expensive) details.
The takeaway here is that it is not what your clients should do to mitigate risks, but actually how they should do it. In other words, entrepreneurs may know what they should do – they build businesses – but advisors can help them with how they should do it and get into the weeds of those details to ensure that they are not glossing over important issues because they believe they are capable and “will just be able to figure it out” when the time comes. Or even worse, the client may put off implementing important safeguards until later because even though bad things happen to others, they believe they are safe from those things happening to them.
Essentially, there is no need to wait for something to go wrong simply because we believe that when that time comes, we will figure it out. Financial advisors know certain things are going to come up, and they can help their clients slow down and address those details that they might not want to address or feel they can just skim over.
Overprecision Reflects An Individual’s Subjective Beliefs About What They Know
While overestimation and overplacement deal with an individual’s perception of the magnitude of their level of ability or competence, or how their ability or competence may stack up relative to others, the third form of overconfidence (overprecision) can be more nuanced. As, unlike the other two types of overconfidence (centered around a general belief that one is better than they really are, or better than a specific group), overprecision addresses what a person believes they really know and their perception of their own accumulated life knowledge. Because of their experiences, they (think that they) ‘know’ they are better, and they can tell you why even if the facts that their belief is based on might be recalled incorrectly. This is no longer just a gut instinct.
In the context of the entrepreneur, we certainly want to respect the life knowledge that leads them to believe X about themselves. Yet, the issue remains that their belief may be an overestimation of their actual ability or capacity.
The takeaway here is that it is not what your clients should do to mitigate risks, but actually how they should do it. In other words, entrepreneurs may know what they should do – they build businesses – but advisors can help them with how they should do it and get into the weeds of those details to ensure that they are not glossing over important issues because they believe they are capable and “will just be able to figure it out” when the time comes. Or even worse, the client may put off implementing important safeguards until later because even though bad things happen to others, they believe they are safe from those things happening to them.
Subjective Probability Interval Estimates (SPIES) Can Help Clients Become More Aware Of Overprecision Issues
Because overprecision can potentially lead to problematic behavior that can result in unwarranted risk-taking, advisors may want to consider how they can help their clients recalibrate skewed beliefs they may have about their own abilities or resources. Specifically, researchers point to a process called Subjective Probability Interval Estimates (SPIES) when facing overprecision issues, which can help to broaden the client’s awareness of the scope or context of potential outcomes. Said another way, it brings other possibilities (not just the one they are tied to) to the discussion. SPIES is a graphical representation of all possible outcomes, where certainly the entrepreneur’s beliefs about themselves could be acknowledged as a piece of data, but is also put in perspective alongside a host of all other possibilities.
Thus, if someone in retirement discovers they are bored and wants to start a business as a second career, it isn’t about telling them no, as much as reorienting their reality.
Example 3: Gabriel, your client, is bored with retirement. Prior to retirement, he was a C-suite executive who loved work. His friends were there. His job was a large part of who he is and, although he does like many aspects of retirement, he misses the feeling of having a purpose.
He wants more social interaction and wants to use his brain more. Moreover, he tells you he has decided to scratch this itch by helping his son to fund a new business venture.
Advisor: Wow, Gabriel, thank you for sharing. It is clear that you are very passionate about this idea. If I may, I would like to walk us through some scenario planning for this plan.
Gabriel: Sure, it is going to be great.
Advisor: I realize you’re confident that it will likely go very well, but I want us to consider all possible outcomes. What I would like for you to do is to look at each of these different possible outcomes and describe for me the likelihood of each.
- Never paid back, never runs a profit
- Paid back after 20 years, little to no profit along the way
- Paid back after 15 years, some profit in some years
- Paid back after 10 years, small profit each year
- Paid back in 5 years, small profit each year
Gabriel: Well, honestly, the only scenario I was playing out was the one where I’m paid back in 5 years with a large profit. So, I see your point. There are many, many more possible outcomes than just wild success. And, in fact, I guess that wild success is actually a very small probability.
Advisor: Yes, success is one of many possible outcomes. I just want us going into this with eyes wide open.
This example is a bit exaggerated and doesn’t perfectly fit the SPIES methodology (most clients probably won’t ‘get it’ quite as quickly as Gabriel does; additionally, the estimated probabilities of each outcome aren’t usually provided, though, in this example, Gabriel is being asked to estimate the probabilities instead), but this modified representation of how SPIES works serves to drive home the main points that, essentially, humans are bad estimators of future outcomes, and when overconfidence is at play, we do not even stop to think about a broader range of outcomes.
In the simple back and forth in Example 3 above, the advisor was able to help Gabriel to recognize his own overconfidence. The advisor didn’t have to say, “No, that is a horrible idea!” or, “Wait, that does not make a lot of sense given the retirement plan we have in place.” Instead, using the SPIES concept helps the client to come to those realizations on their own.
In the end, the goal for financial advisors working with overconfident clients is not to encourage them to abandon their overconfidence. Instead, presenting clients with enough knowledge to help them understand how the actual risks they may be facing can impact their situation (and how those risks may pose very real threats to them, which can arise through the actions of other, potentially less skilled/knowledgeable individuals over whom the client has no control – no matter how lucky they may feel) can be the cornerstone for creating a sound financial plan, that still takes prudent risks… but with all the appropriate safeguards in place!
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