We Should Totally Open a Restaurant : How Optimism and Overconfidence Affect Beliefs

Overestimating the probability of high-payoff outcomes is a widely-documented phenomenon that can affect decision-making in numerous domains, including finance, management, and entrepreneurship. In this paper, we design an experiment to distinguish between two often-confounded beliefs biases, optimism and overconfidence, both of which can explain why individuals over-estimate the probability of high-payoff outcomes. Optimism occurs when individuals, independent of their own performance, over-estimate the probability of outcomes they prefer. Overconfidence occurs when individuals believe they perform better than they actually do. We find that optimism and overconfidence are positively correlated at the individual level and that both optimism and overconfidence help to explain why individuals over-estimate high-payoff outcomes. Our findings challenge previous work that focuses solely on overconfidence to explain behavior. The reason is that ignoring the role of optimism results in an upwardly biased estimate of the role of overconfidence. To illustrate the magnitude of the problem, we show that 30% of our observations are misclassified as under- or over-confident if optimism is omitted from the analysis