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Overconfidence and diversification

Heller, Yuval (2010): Overconfidence and diversification.

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Abstract

Experimental evidence suggests that people tend to be overconfident in the sense that they overestimate the accuracy of their own predictions. In this paper we present a principal-agent model in which principal's interest in diversification motivates him to hire overconfident agents. We show that the induced overconfidence satisfies experimental stylized facts. In addition, we show that overconfidence is a unique evolutionarily stable strategy, and that it can Pareto-improve social welfare. Finally, we demonstrate applicability by demonstrating why CEOs hire overconfident intermediate managers, and why investors prefer overconfident entrepreneurs.

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