Are Entrepreneurs Victims of the Lake Wobegone Effect?


Interesting new research from Gavin Cassar at Wharton, shows that entrepreneurs are overly optimistic when they launch their ventures. In a study that covered 5 years, entrepreneurs were followed to see if their business ideas became real companies, and whether or not their initial expectations were accurate. One interesting result of the research is that financial modeling and scenario planning actually increase over-optimism.

More generally, the findings also show how the use of information may lead the nascent entrepreneur to dysfunctional beliefs. In particular, the use of information in a manner consistent with an inside view, involving the use of plans, projections, or causal scenarios to successful outcomes, is associated with more optimistic expectations in nascent entrepreneurs.

In part, this is driven by Lake Wobegone syndrome – the idea that we all think we are above average at most things. It is also unknowingly driven by the banks, angels, and VCs, who require financial projections in order to analyze a request for capital.

Many financial intermediaries require ventures to submit financial projections in order to be eligible for financing. Such behavior is considered good business practice and not only provides potential financiers with information concerning the investment project, but also signals the competence and quality of the management team. The empirical findings show that the act of preparing financial statements is associated with more optimistically biased sales projections.

Why is this important? Because contrary to what you might read on Digg, starting a business is decision that should be taken seriously, and you have to factor in your optimistic bias.

The paper does point out one thing that lowers the optimism bias – real market data. That's why the startup process can't take place in a vacuum. Talk with potential customers, find out what your inputs really cost, and what price your outputs can fetch. See if anyone really likes what you have to offer. Confidence is a good thing for an entrepreneur, but blind optimism can be an expensive mistake.

You can download the full paper here.

  • That’s really interesting Rob – you always dig up the greatest articles.

    Here’s a thought though: Isn’t optimism, even irrational optimism almost a requirement for entrepreneurs?

    A completely delusional belief in your own magical abilities is bad, sure, but I feel that a slight tendency to overvalue your own skills and to view the situation you’re in a little more positively than the hard facts warrant is actually a startup’s best weapon.

    Martin Seligman’s research showed that optimists are more successful than pessimists (I’m not sure if he ever compared realists and optimists).

  • Rob

    That’s a good point. I’ve read Seligman’s work and I think it holds up. I guess the best way to phrase my view is that entrepreneurs need to make sure that they understand how difficult it will be, but have optimism that they can overcome it, as opposed to having optimism that their product will take off quickly and their ramp up will be easy.

  • sean

    How does one quantify OVERLY optimistic?

    Why would someone start a business if they were not optimistic?

  • Matt

    The thing is, there’s no such thing as “realism” in an entrepreneur. Either you think things will go well (in which case you’re classed as an optimist) or you think they’ll go badly (in which case, if you’re stupid enough to start the business _anyway_, you’re counted as a pessimist). “Realistic” is a description that can only be applied in retrospect, because no business plan ever survives first contact with the customer base. :)

    I’d discount the significance of a study in which “accuracy of initial expectations” is counted as a necessary component of a rational view of probability. Frankly, if your initial expectations are accurate, you should quit business and go play the lottery…because that’s ultimately a matter of luck as much as skill. What counts isn’t guessing right the first time, it’s ability to adapt to the things you find out mid-stream that you guessed wrong about.

  • The only way to build a business under stressful conditions is to be optimistic. I am going through it now… and my “angel” said those very words to me today. sitting in his office he turned around to me and said “how did you think I built all of this, by being negative?”…. its a requirement to be optimistic… becuase most entrepreneurs come up against people who are pessimistic on what you are doing…