Reference Group Neglect

The problem of why enterpeneurs start up companies is an interesting one. Many fail but it doesn’t seem to put them off. Colin Camerer and Dan Lovallo examined a possible reason for this. (They examine it in a lab so can’t give definitive answers but it is still interesting.) The authors use a small game to examine if their respondents a) don’t understand that most ventures fail (lack of knowledge of the rate of success), or b) they think failure just won’t apply to them (overconfidence about their own personal ability to increase the chance of success). Camerer and Lovallo conclude that even when we know the chance of success we think we are special and the low chance of success won’t apply to us.

They outline an interesting phenomena that I often allude to in class, reference group neglect. This idea captures that fact that in competition we often pay little attention to the skills of those whom we are competing with. For example, Emma enters a chess competition and thinks she will do well because she knows she is a good chess player, much better than the friends she plays with. The problem is that entry to a chess tournament (or any number of other activities) isn’t random. People who enter chess tournaments tend to be very good at chess — that is why they entered. Knowing how good we are isn’t enough to predict how we’ll do in a competition of relative ranking — we need to know how good everyone else is. This feeds back to market entry — when setting up a small business the founders know they are talented and hard working. They don’t, however, recognize that this is true of many starting their own businesses. Many talented, hardworking people still fail in great numbers.

The logic applies to movies. All studio executives think their movie-making and marketing teams are great. The studio executives may be correct — but not all movies can be great hits. Similarly, sporting stars in high school are likely to find themselves merely mediocre when going to university or turning professional. The group they are competing with is simply of a much higher standard.

“Reference group neglect is one byproduct of a psychological phenomenon called the “in-side view”” (Camerer and Lovallo, 1999, page 315). To solve this always try and think about your position objectively. Consider that the same strengths that encourage you to compete are probably shared by those competing with you — that is why they choose to do so. As such it really matters whether you were forced to compete — one might expect the competitors to be merely average — compared to when others chose to compete with you — they are likely to be much better at it than the average person.

Read: Colin Camerer and Dan Lovallo (1999) “Overconfidence and excess entry: An experimental approach.” The American Economic Review 89 (1) 306-318.