Do overconfident and over‐optimistic entrepreneurs invest too much in their companies? Theory and evidence from Italian SMEs

• Published in: Strategic entrepreneurship journal 2022-12, Vol.16 (4), p.769-800
• Main Authors: Cervellati, Enrico Maria, Pattitoni, Pierpaolo, Savioli, Marco
• Format: Article
• Language: English
• Subjects: Entrepreneurs; overconfidence; overinvestment; overoptimism; Small & medium sized enterprises-SME; Small business; under‐diversification
• ISSN: 1932-4391; 1932-443X
• DOI: 10.1002/sej.1421

Research Summary Entrepreneurs often invest a large share of their personal wealth in their firms, exposing themselves to idiosyncratic risk. We propose a theoretical model showing how overconfidence and overoptimism may help to explain this evidence. We focus on overprecision, but we also consider overestimation and overplacement. Numerical examples show a more substantial role for overconfidence than overoptimism in determining entrepreneurs' portfolio allocations. We test the effect of the two latent variables—overconfidence and overoptimism—on small business owners' portfolio allocations. We use a unique dataset including private information on Italian small and medium enterprises and a structural equation modeling approach. A positive relationship between overconfidence and entrepreneurs' investments in their own companies is confirmed. Managerial Summary We propose a theoretical model showing how overconfidence and overoptimism explain the evidence that entrepreneurs invest a large share of their personal wealth in their firms, exposing themselves to specific risk. Overconfidence leads to underestimating risk, while overoptimism to overestimate expected returns. Using numerical examples, we show a more substantial role for overconfidence than overoptimism in determining entrepreneurs' portfolio allocations. Using a unique dataset including private information on Italian small and medium enterprises, we test our model and find a positive relationship between overconfidence and small business owners' investments in their own companies.