Received: 23 June 2017 Revised: 8 March 2018 Accepted: 18 March 2018

DOI: 10.1002/mde.2931

RESEARCH ARTICLE

Overconfidence and disappointment in venture capital decision

making: An empirical examination
Samuel B. Graves | Jeffrey Ringuest

Carroll School of Management Boston

College, Chestnut Hill, MA, USA We examine the effects of overconfidence in venture capital investing. Overconfi-
Correspondence dence in financial decision making is a robust, well‐established finding, and its conse-
Samuel B. Graves, Carroll School of
Management Boston College, 140 quences for decisions by equity market investors, startup entrepreneurs, and CEO's of
Commonwealth Ave., Chestnut Hill, MA large firms have been comprehensively examined and documented. This paper con-
02467, USA.
Email: graves@bc.edu siders the behavioral consequences of overconfidence by venture capitalists, compar-
ing their anticipated returns to actual average returns. Our primary metric is Bell's
disappointment, a measure of the difference between anticipated and actual payoff.
We construct both deterministic and stochastic models, based on empirical data.
We find that the average venture capitalist will experience substantial
disappointment.

1 | I N T RO D U CT I O N behaviors have been observed in humans over many regions of the

Traditional models of financial decision making are founded on
the axioms of fully rational economic agents (Thaler, 2000, Henrich
et al., 2001). Increasingly, however, systematic and consequential
departures from this archetype have been observed and documented.
Kahneman and Tversky (1974) initiated the study of these anomalies
with their pioneering scholarship on biases and heuristics. Their work
has been followed by that of many other scholars in the growing fields
of behavioral economics and finance (see surveys, e.g., in Barberis &
Thaler, 2003; Baker & Wurgler, 2011).
One particularly well substantiated departure from pure rational-
ity is overconfidence, increasingly recognized as a widespread, if not
universal, attribute of financial decision makers (Johnson & Fowler,
2011). In fact, De Bondt and Thaler (1995) describe overconfidence
as “perhaps the most robust finding in the psychology of judgment”
(p. 389). Johnson and Fowler (2011) argue further that overconfidence
is common to the human species as a result of evolutionary forces.
They contend that overconfidence yielded evolutionary advantages
in the form of enhanced ambition, self‐esteem, determination, and
perseverance and that an unbiased assessment of one's own capabili-
ties was not necessarily optimal under conditions of uncertainty and
asymmetric costs for different error types. Brennan and Lo (2012) cite
the accumulating empirical and experimental data showing that human
economic decisions are commonly suboptimal, especially when risk
and uncertainty are present. They lend strong support to the evolu-
tionary basis of suboptimal behaviors, noting that similar anomalous
earth and even in other primates. And Griffin and Varey (1996) argue
(without reference to evolutionary origins) that overconfidence “may
be adaptive in at least some circumstances where the increased confi-
dence is linked to increased enthusiasm and tenacity” (p. 228).
In this paper, we will examine the consequences of overconfi-
dence in financial decision making, focusing our analysis on the
funding decisions of venture capitalists (VCs). We begin with a review
of the literature covering primarily the effects of overconfidence
among equity market investors, entrepreneurs in startup businesses,
and CEO's and then turn attention to our main focus, overconfidence
in venture capital decision making. Using a simple analytical model
adapted from that in Ringuest and Graves (2016), together with some
empirical evidence from Zacharakis and Shepherd (2001), we are able
to estimate actual values of Bell's disappointment for typical venture
capitalists. Accordingly, this paper is the first to address the question
“what are the approximate levels of disappointment actually experi-
enced by venture capital investors?” This paper provides, to our
knowledge, the first published estimate of these quantities. Hence,
our work enhances the growing stream of research addressing system-
atically suboptimal, and in particular, overconfident decision making in
economics and finance.
Our paper will proceed in the following sequence. First, we
explore the existing scholarship regarding overconfidence and its
effects, finding substantial impacts in multiple managerial settings.
We then develop our model, which, following Ringuest and Graves
(2016), estimates the expected value of Bell's disappointment metric

592 Copyright © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/mde Manage Decis Econ. 2018;39:592–600.
GRAVES AND RINGUEST
as a function of the decision maker's true predictive accuracy. We
perform this analysis for both deterministic and stochastic treatments
of true predictive accuracy. Immediately below, we begin with our
review of the literature of overconfidence and its financial and eco-
nomic consequences.
2 | OVERCONFIDENCE: EVIDENCE AND
E C O NO M I C C O N S E Q U E N C E S
Overconfidence in business and financial decisions has significant con-
sequences. Barber and Odean (2001), for example, find significant
economic effects of overconfidence among equity market investors.
They base their work on previous findings that, on average, men are
more overconfident than women (Lundeberg, Fox, & Punćcohaŕ,
1994), and thus (using gender as a proxy for overconfidence level),
they compare the performance of male and female investment
professionals. They find that excessive trading among males reduces
net returns by almost a full percentage point compared with female
investors. And in a related result, Odean (1998) finds that overconfi-
dent equity traders suffer a loss in expected utility because they hold
under‐diversified portfolios.
In another business setting—a study of overconfidence among
startup companies—Cooper, Woo, and Dunkelberg (1988) examined
a sample of 2,994 entrepreneurs who had been in business for a
median period of 12 months. They asked each of these managers to
estimate her/his own probability of success. From this sample, 81%
felt that their success probability was at least 70%, and fully one third
estimated their success probability at 100%. Their overconfidence is
manifested by the evidence: only between 25% (Salamouris, 2013)
and 50% (Cooper et al., 1988) of such businesses actually survive
beyond 5 years.
In a study of the consequences of overconfidence at the highest
levels of the firm, Malmendier and Tate (2005) studied the behavior
of CEO's at 477 publicly traded U.S. firms over the period 1980 to
1994. They found that CEO overconfidence led to distortions in
corporate investment policies and suboptimal investment decisions.
In a later paper, they found that overconfident CEO's “overpay
for target companies and undertake value‐destroying mergers”
(Malmendier & Tate, 2008, p. 20). Further, Deshmukh, Goel, and
Howe (2013), using the same data set as Malmendier and Tate
(2005), found that overconfident CEOs promulgate suboptimal divi-
dend policies.
Countering the possibility that such overconfidence in financial
affairs is a uniquely American trait, Aukutsionek and Belianin (2001)
found that Russian managers were decisively overconfident about
their accuracy level in predicting economic indicators such as wages,
employment, output, and real investment in their own sector of exper-
tise. Yates, Lee, Shinotsuka, Patalano, and Sieck (1998) examined
cross‐cultural differences in overconfidence, though not in a business
context. They found variations in the levels of overconfidence among
subjects in some Asian countries, but in general, overconfidence
prevailed. And yet another study, this one of Asian managers in a busi-
ness context, confirmed the presence of overconfidence in that set-
ting (Wright & Phillips, 1980). Finally, Yates et al. (1989), in a study
593
of subjects in China, Japan, and the USA, found similar levels of over-
confidence in these countries.
In a distinct institutional acknowledgement of the pervasiveness
of overconfidence, the UK Treasury Department publishes adjustment
factors to mitigate the effects of overconfidence by construction con-
tractors who bid on government building contracts (Her Majesty's
Treasury, 2003). Government officials are directed, for example, to
increase a contractor's estimated duration of nonstandard government
building construction by up to 39% and cost by up to 51%.
And finally, Russo and Schoemaker (1992), examining over 2,000
managers in a range of businesses including advertising, computers,
data processing, money management, petroleum, pharmaceuticals,
and security analysis, found that more than 99% of those individuals
exhibited some level of overconfidence.
In this brief review, we have seen substantial overconfidence
among equity market investors, startup entrepreneurs, CEO's in large
firms, and government contractors. In the next section, we will turn
our attention exclusively to overconfidence among venture capitalists.
3 | O V E R C O N F I D E N C E I N V E N T U RE
CAPITAL INVESTMENT
The focus of this study is overconfidence among VCs. Zacharakis and
Shepherd (2001), in a study of overconfidence among VCs, found that
they, like other decision makers, are generally overconfident, conclud-
ing that “VC investment decisions are biased by overconfidence. This
overconfidence negatively affects decision accuracy” (p. 328). In the
case of VCs, our metric of overconfidence is the excess of their
confidence level about the success of new ventures over their true
accuracy in predicting successful new ventures. Zacharakis and
Shepherd (2001) assembled a data set illustrating VC overconfidence
which is illustrated in Figure 1.
The horizontal axis shows the mean accuracy of a sample of VC's
in predicting the success of a series of 50 completed ventures for
which the outcomes were known (but not revealed to participants in
the sample). The vertical axis shows the corresponding mean confi-
dence value of each VC in their own predictions. (To measure
FIGURE 1 Confidence versus accuracy of venture capitalist (VC)
predictions (data from Zacharakis & Shepherd, 2001, n = 50) [Colour
figure can be viewed at wileyonlinelibrary.com]
594
confidence, each participating VC noted their confidence in each
prediction on a 7‐point Likert scale, and the result was normalized to
a 100 point basis.)
In these data, true VC predictive accuracy levels ranged from 0%
to 60% with a mean of 29.2%. The corresponding confidence values
ranged from about 35% to 94% with a mean of 65.6%. Hence, sub-
stantial overconfidence is apparent, with mean confidence more than
double the mean accuracy.1
At this point, before continuing further, it is important to distin-
guish between the various categories of overconfidence which we will
be discussing henceforth. According to most scholars in this area of
study, there are three forms: (a) illusion of control, (b) calibration‐
based overconfidence (CBO), and (c) better‐than‐average (BTA) over-
confidence. The first of these, illusion of control, first defined by
Langer (1975), refers to the tendency of a decision maker to believe
that she/he enjoys some level of influence over the outcome of a
purely (or mostly) random process. For example, a decision maker
might feel that he/she was endowed with “good luck” in predicting
stock market outcomes, when, of course, this would be impossible.
This form of overconfidence is not relevant to our analysis and will
not be pursued further here.
The second form of overconfidence, CBO, refers to the tendency
of decision makers to underestimate the variance of the probability
distributions from which future events will be drawn, or more simply,
they tend to overestimate the precision of their knowledge. Russo and
Schoemaker (1992) studied CBO and estimated its magnitude across a
number of industries. They found comparable levels of CBO among a
number of business types. For example, when managers were asked to
estimate 90% confidence intervals for particular aspects of their own
industry (which in the absence of overconfidence would yield a 10%
error rate), the actual error rates they achieved were as follows:
advertising, 61%; data processing, 42%; money management, 50%;
and security analysis, 64%, all substantially overconfident. The only
business field identified in the literature which does not seem to
exhibit overconfidence is public accounting. In fact, a study by
Tomassini, Solomon, Romney, and Krogstad (1982) showed systematic
underconfidence in this field. Russo and Schoemaker (1992) suggest
that this may be explained by the accounting profession's intense
emphasis on conservative interpretations, combined with their func-
tion as auditors, alert for fraud or deceit.
Deaves, Lüders, and Schröder (2010) studied CBO among stock
market forecasters and found that they, too, consistently estimated
excessively narrow confidence intervals for future stock market levels.
And Radzevick and Moore (2011) provide an interesting additional
explanation for the CBO form of overconfidence in business and
financial forecasts. Based on experimental work, they found that con-
sumers of financial forecasts favor advisors who express more confi-
dence that they (the advisors) have the right answer. Similarly,
Radzevick and Moore (2011) find that “market competition magnifies
a bias present in individual judgements” (p. 104). Consequently,
market forces—in addition to the evolutionary influences noted
above—motivate those who are selling advice or expertise to make
overconfident statements. Radzevick and Moore (2011) conclude that
“overprecision, the excessive certainty that one has the right answer,
is the most robust variety of overconfidence” (p. 94).
GRAVES AND RINGUEST
The third category of overconfidence, BTA, results from the belief
by the decision maker that his/her ability to assess future events is
just better than that of other decision makers. This is sometimes
labeled the “Lake Wobegon effect,” under which the decision maker
simply believes that his/her information endowment or decision‐
making ability is superior to others.
In this paper, we will assess and compare the second two of these
forms of overconfidence, CBO and BTA.
Our study follows closely the pattern of an earlier work by
Ringuest and Graves (2016). They studied overconfidence in an indi-
vidual investment performance setting, comparing outcomes for a
market timer to results for a buy‐and‐hold investor, finding, inter alia,
that market‐timing investors will generally be disappointed with their
results. That is, actual investment results of market‐timers will, on
average, fall short of their (overconfident) expectations. Ringuest and
Graves were able to quantify this disappointment, but their study suf-
fered from the important limitation that their estimates of accuracy
and confidence, though reasonable and plausible, were entirely sub-
jective. The current study enjoys the noteworthy advantage of empir-
ical estimates of accuracy and confidence, taken from the sample data
of Zacharakis and Shepherd (2001) and summarized in Figure 1 above.
In the current study, we need first to clearly distinguish between
the decision maker's true predictive accuracy and their assumed pre-
dictive accuracy. We will use the term “conjectural predictive accu-
racy” to refer to the VC's subjective belief about the accuracy of
her/his investment predictions. We will use the designation “true pre-
dictive accuracy” to refer to the actual accuracy exhibited by the VC.
Conjectural predictive accuracy will be denoted p’ and true predictive
accuracy by p. Overconfidence, then, is defined as (p’ – p), the excess
of conjectural accuracy over true predictive accuracy. These designa-
tions and denotations follow Ringuest and Graves (2016).
Before beginning our analysis, we will review the empirical distri-
bution of true predictive accuracy among advisors in the Zacharakis
and Shepherd (2001) data set, shown in Figure 2. Here, we can see
that the modal interval for true predictive accuracy extends from
0.30 to 0.40; notably also, the distribution is skewed to the left. This
FIGURE 2 Distribution of venture capitalist's (VC's) true predictive
accuracy (data from Zacharakis & Shepherd, 2001) [Colour figure can
be viewed at wileyonlinelibrary.com]
GRAVES AND RINGUEST
empirical distribution provides a basis for choosing realistic parameter
values in our analysis which begins in the next section.
4 | ANALYSIS
In this analysis, we will compare the expected value of the investment
results of a venture capitalist (an individual VC investing in a single
venture) to the results of a buy‐and‐hold equity index fund investor,
in each case over a period of 5 years. We designate Investor A the
index fund investor and Investor B the VC. Their assumed investment
behaviors are as follows:
• Investor A simply invests in an S&P 500 market index fund for a 5‐
year period and receives an expected annual return of ra.
• Investor B, on the other hand, evaluates a particular venture and
then, if she/he predicts success, invests in that venture for a hold-
ing period of 5 years. If the venture is successful, then the VC
receives a return of M%. If the venture fails, he/she suffers a loss
of all invested funds. If Investor B predicts that a venture will be
unsuccessful, then he/she simply invests those funds in an S&P
500 equity market index fund (for a 5‐year period) with an
assumed annual return based on historical returns from the S&P
500. We denote the VC's expected annual return rb; it accounts
for both successful and failed ventures and for periods of invest-
ment in an equity index fund.
4.1 | Data
We now turn our attention to estimation of the applicable rates of
return and probability of success for a single venture. First, we confine
our attention to successful ventures. Zider (1998, p. 135) states that
for successful ventures, VCs “expect a ten times return of capital over
five years.” This converts to a 59% annual rate of return. Cochrane
(2005) constructs an empirical estimate of the mean of rate of return,
based on VC data from 1987 to 2000. His empirical estimate, based
on these data, is also a 59% annual rate of return for successful
ventures. Considering these estimates, we arrive at a base‐case value
of M = 900%, the equivalent of a return of 10 times capital over
5 years. A complete failure of the venture would result in a loss of
(M/9)%, that is, a loss of 100%.
We assume an average equity market return of 50% per 5‐year
period. This is derived from the fact that the (geometric) mean return
for the S&P 500 for the 50‐year period 1966–2015 is 9.61% and the
(geometric) mean return for the 10‐year period 2006–2015 is 7.25%.
Cumulating each of these two averages over a 5‐year period produces
58.2% in the first instance and 41.9% in the second (data are from
New York University, 2015). Based on these data, we will take 50%
as an approximate 5‐year‐average return on the S&P 500.
The model which we introduce in the next section requires (in
addition to the rates of return approximated above) estimates of the
success or failure of a given venture. Table 1 below gives a number
of such estimates and approximations. Based on these data, we take
0.50 as our base‐case value for the probability of a successful venture.
595
In our model, however, we will conduct excursions on this probability
down to 0.20 and as high as 0.60.
Intuitively, a 50% success estimate may appear rather high for
risky new ventures. However, this probability is actually conditioned
upon passing rigorous screening in order to get VC funding. In fact,
Kunze (1990), a successful VC, depicts his vetting process this way:
“In practice I screen out 99% of the business plans submitted to me”
(p. 26). And further, “Each year I seriously evaluate 25 business pro-
posals but I only invest in two or three” (p. 91). These two screens
in sequence would eliminate most proposals, so that our success prob-
ability, 0.50, is conditional and would apply only to those proposals
that pass these two screens and actually get funding.
4.2 | The model
In order to evaluate the effects of overconfidence on the VC's practice
and experience, we will follow Ringuest and Graves (2016) to develop
an expression for the VC's expected surplus return. Expected surplus
return, consistent with the definition given by Ringuest and Graves
(2016), is the expected excess performance of the VC (Investor B)
over the equity index fund investor (Investor A).
We define the following terms:
f: Five‐year return on the equity index fund (in percent)
S: The event: venture is a success
F: The event: venture is a failure
P: The event: VC predicts a successful venture
N: The event: VC predicts a failed venture
Table 2 shows the four possible outcomes to which Type B inves-
tors are exposed over a 5‐year horizon.
Investor A is constantly exposed to the equity market with
expected annual return f, so that
ra ¼ f:
The expected return to Investor B, rb, however, depends on both
the likelihood of a successful (or unsuccessful) outcome, and Investor
B's ability to correctly predict the outcome. The expression for rb
then is
TABLE 1 Venture success probability values derived from multiple
sources
Source P(S)
Kunze (1990) 33–67%
Zider (1998) 40%
Gage (2012) 60–70%
Ghosh and Nanda (2010) 50%
Gompers, Kovner, Lerner, and Scharfstein (2008) 55%
Mason and Harrison (2002)a 50%
These P(S) values are not necessarily precisely those quoted by these
sources, rather they are our own summary estimates based on data in
each of the sources.
a
Mason and Harrison studied 128 venture capitalist investments in the UK,
finding 34% a total loss, 13% partial loss or breakeven, a success rate, of
about 53%.
596
TABLE 2 Possible outcomes to Investor B
Actual outcome of venture (% gain or loss)
Investor B's prediction Success (S) Failure (F)
Success (P) M −M/9
Failure (N) f f


rb ¼ PðPjSÞPðSÞM þ PðPjF ÞPðF Þ − M=9 þ PðNjSÞPðSÞf
þ PðNjFÞPðF Þf:
If we now assume that Investor B's predictive accuracy is sym-
metric, that is, P(P|S) = P(N|F), and substitute for brevity, p = P(P|
S) = P(N|F), Equation (1) becomes
−


rb ¼ pPðSÞM þ ð1−pÞPðFÞ M=9 þ ð1−pÞPðSÞf þ pPðFÞf:
Expected surplus return can now be written as follows:
RðpÞ ¼ r b −ra ;

that, if funded, 100 of these will ultimately be successful (latent suc-
¼ pPðSÞM þ ð1−pÞPðF Þ − M=9 þ ð1−pÞPðSÞf þ pPðF Þf− f:
As stated above, we will use a probability of 0.50 as our base‐case
value for P(S), with excursions down to 0.20 and up to 0.60, consistent
with empirical data.
4.3 | The surplus return metric
To examine surplus return, R(p), as a function of P(S), we have devel-
oped Figure 3 below which shows the results of Equation (3) for P(S)
values incremented from 0.20 to 0.60, whereas M = 900% and
f = 50% (estimated 5‐year equity index returns). As we noted above
in the data from Zacharakis and Shepherd (2001), actual VC accuracy
levels ranged from about 10% to about 60%. For our base case, with
P(S) = 0.50, only about 13% of the VC's in the sample would suffer
negative R(p) values. With a lower accuracy level of P(S) = 0.40, 19%
of the sample would see negative values. And at P(S) = 0.20, about
38% of VC's in the sample would see negative R(p) quantities.
FIGURE 3 R(p) as a function of predictive accuracy, p For P(S) = 0.20,
0.30, 0.40, 0.50, 0.60 [Colour figure can be viewed at
wileyonlinelibrary.com]
GRAVES AND RINGUEST
However, taking the average predictive accuracy of about 30%
from Zacharakis and Shepherd (2001; shown as the vertical line in
Figure 3), we see that for P(S) ≥ 0.30, the VC has positive and conceiv-
ably large positive values of R(p). In a typical case, where p ≈ 0.30 and
P(S) = 0.50, the VC's results exceed those of the equity index fund
investor by 76.5 percentage points over a 5‐year period or about 12
percentage points per year compounded. Simply basing our analysis
on surplus return, then, it seems many VC's would be quite content
to beat the equity index by 12% per year. In the next section, we will
(1)
examine the VC's results based on a disappointment measure and
determine if, based on that metric, she/he would still be satisfied.
At this point, to avoid confusion, it may be useful to reiterate and
clarify the distinction between P(S), an individual project's success
probability, and p, the VC's true predictive accuracy. P(S) is simply
(2) the marginal probability of success for a given project that a VC has
decided to fund. And, as previously stated, p is the conditional proba-
bility of a correct prediction by the VC, that is, p = P(P|S) = P(N|F).
To illustrate, suppose 200 projects are on the VC's desk and have
passed her/his initial screening. Our base‐case P(S) of 0.50 requires
(3) cesses) and 100 will fail (latent failures). Because p = .30, the VC will
be correct 30% of the time in identifying actual successes from the
100 latent successes. Thus, he/she will correctly classify 30 of these
latent successes and misclassify 70. Likewise, she/he will correctly
identify 30 and misclassify 70 of the latent failures.
4.4 | The disappointment metric
In our next step, again following Ringuest and Graves (2016), we turn
our attention to disappointment as a metric. That is, for a given VC,
with overconfidence (p’ − p), how does the surplus return that he/she
actually receives compare with the surplus return that she/he
anticipated?
We base our disappointment measure on the concept developed
by Bell (1985), simply the difference between the anticipated gain
and the actual gain on an uncertain transaction. The anticipated gain
is the reference point to which the actual outcome is compared. Bell's
disappointment joins other “reference effect” phenomena in which the
decision maker's satisfaction with the outcome of a random event
depends on some exogenous reference point.
In prospect theory (Kahneman & Tversky, 1974), for example, the
decision maker's satisfaction with an outcome depends on its distance
from the original status quo. Regret theory (Loomes & Sugden, 1982)
takes as its reference point the outcome associated with the optimal
choice by the decision maker. The decision maker's satisfaction with
an outcome depends on its difference from the outcome obtained
under optimal choice (the reference point). Bell's disappointment, in
contrast, takes as its reference point the outcome that the decision
maker anticipates. Disappointment then is the difference between
the payoff of the anticipated outcome (the reference point) and the
payoff of the actual outcome.
Ericson and Fuster (2011) provide experimental evidence that the
relevant reference point in human behavior is often this anticipated
outcome. As they state it, “individual's reference points are deter-
mined, at least in part, by expectations” (p. 1900). They make the case
GRAVES AND RINGUEST
that among the currently identified reference points— status quo, the
payoff under optimal choice, and the payoff under the anticipated
result—the anticipated result may be the most important of the human
reference points. This provides added support for the use of Bell's dis-
appointment in our paper.2
Bell concedes that use of disappointment minimization as an
objective function may reduce the economic efficiency of a decision
but argues, nonetheless, that avoidance of disappointment may pro-
duce intangible psychological rewards for the decision maker. We find
the disappointment metric especially appropriate in the context of
overconfidence, because it highlights the gap between the decision
maker's anticipated payoff, based on p’ (the decision maker's conjec-
tural predictive accuracy) and the actual outcome conferred upon
the decision maker based on p (the decision maker's true predictive
accuracy).
Using this surplus return metric, then, the expected value of the
VC's disappointment, Db, would be
Db = R(p') ‐ R(p), resulting in
   
′
Db ¼ p −p PðSÞð:89M−2f Þ þ f þ M 9 : (4)
Plotting Equation (4) for various levels of conjectural accuracy, p’,
produces Figure 4 below, where positive values of Db represent disap-
pointment to the decision maker. Negative values signify performance
exceeding anticipated (designated “elation,” by Bell, 1985). Once
again, based on Zacharakis and Shepherd (2001) data, we use a mean
true predictive accuracy, p, of 30% and a mean conjectural predictive
accuracy, p’, of 66%.
Interpolating in Figure 4, a typical decision maker (p ≈ 0.30,
p’ ≈ 0.66) would experience a disappointment level of about 180%,
meaning that the (5‐year) average result achieved would be about
180% below that which was anticipated. And for a typical decision
maker with conjectural accuracy of p’ = 0.66, true predictive accuracy
would, of course, need to be at least 0.66 to avoid disappointment
altogether.
Further, from Figure 4, we can see that those VC's in the bottom
25% of Zacharakis and Shepherd's (2001) sample (those below about
20% true predictive accuracy) would experience a minimum of 165%
FIGURE 4 Db as a function of true predictive accuracy, p, and
confidence level, p’ P(S) = 0.50 [Colour figure can be viewed at
wileyonlinelibrary.com]
597
(5‐year) disappointment. The worst 10% would experience at least
220% (5‐year) disappointment.
These disappointment levels are quite high compared with the
quantities estimated in Ringuest and Graves (2016), where Db was
4.58% (for 1 year) for a typical investor with (assumed) predictive
accuracies of p = 0.50 and p’ = 0.80. Even after compounding Db over
5 years, they observe an estimated disappointment of only about 25%,
almost an order of magnitude smaller than those we have estimated
above for VCs. Of course, Ringuest and Graves' (2016) estimates were
derived by comparing a market‐timing equity investor's results with
those of a buy‐and‐hold equity investor. So, large differences in disap-
pointment levels may reflect, inter alia, the disparity in risks and
potential gains between these two scenarios. In the Ringuest and
Graves (2016) paper, the ratio of risky return to safe return is about
5, whereas that same ratio in the current paper is close to 20.
Earlier in this paper, using surplus return over an index fund inves-
tor as our measure, we speculated that a VC might be quite content to
beat the index investor by around 12% per year. Now, however, using
disappointment as our metric, a different picture emerges. The typical
VC would experience on the order of 180% (5‐year) disappointment or
about 23% per year compounded. It seems unlikely that this investor
would still be content when measured against this benchmark.
4.4.1 | Stochastic treatment of true predictive
accuracy
In the discussion above, we treated the decision maker's true predic-
tive accuracy level, estimated from Zacharakis and Shepherd (2001)
data, as deterministic. A casual glance at Figures 1 and 2, however,
shows considerable dispersion in the true predictive accuracy of
VCs. And we will argue, even for a single VC, it is reasonable to model
true predictive accuracy as a random variable. Zacharakis and Shep-
herd (2001) describe the VC's decision‐making process as a highly
complex task in an exceedingly uncertain environment. Moreover,
according to Zacharakis and Shepherd (2001), the time pressures asso-
ciated with these decisions (from competitive forces) result in cogni-
tive overloads, reducing the VC's ability to assess the pertinence of
various inputs. In a similar vein, Baron (1998) lists three factors which
tend to induce error into these analytical processes: cognitive over-
load, high levels of uncertainty, and elevated levels of emotion. Each
of these factors is likely to be present in the VC's decision‐making
environment.
Tyebjee and Bruno (1984) highlight the complexities and ambigu-
ities of the VC decision‐making process. The typical VC, they say, usu-
ally aided only by a small organization, must search through a large
number of potential projects in a tumultuous environment. And
further, potential projects typically present scant data on operating
history.
Taking these issues into consideration, it seems appropriate to
examine the effect of modeling true predictive accuracy as a random
variable.
Our stochastic model of true predictive accuracy closely follows
that of Ringuest and Graves (2016). However, our treatment offers a
significant advance in that, as previously noted, we have empirical
estimates of p, the VC's true predictive accuracy, and p’, the VC's
598
conjectural predictive accuracy along with the full empirical distribu-
tion of p values.
We will treat the variable p as a random variable following a trian-
gular distribution with parameters a, b, and c. Following the usual
convention, a is the lower limit, b the upper limit, and c the mode of
the distribution. We wish to find the VC's expected disappointment
associated with various values of the parameters, a, b, and c. We find
expected disappointment simply by replacing p in Equation (4) with
E(p), resulting in
 
 
EðDb Þ ¼ p′ −EðpÞ PðSÞð:89M−2f Þ þ f þ M 9 : (5)
And, for the triangular distribution, E(p) = (a + b + c)/3, so that
 
aþbþc   
EðDb Þ ¼ p′ − PðSÞð:89M−2f Þ þ f þ M 9 : (6)
3
We now evaluate (6) for a variety of values for parameters, a, b,
and c. Initially, we will set the mode of the triangular distribution,
c = 0.30, approximating the mean of the Zacharakis and Shepherd
(2001) data in Figure 1, and will assign a = 0 and b = 0.60, the mini-
mum and maximum values for true accuracy in the Zacharakis and
Shepherd data set (in this instance, we are assuming a symmetric dis-
tribution, so the mean and mode would be equal.)
Although holding the a and b values constant, we allow the mode
of the triangular distribution on p to range from 0.30 to 0.60, produc-
ing the results in Figure 5. The behavior of E(Db) related to the mode,
c, is entirely predictable. As we increase the modal value of true pre-
dictive accuracy, disappointment decreases.
In observing the effect of increasing the upper limit, b, (and thus
the range) on the triangular distribution on p (i.e., stepping downward
among the three curves), we see that, ceteris paribus, disappointment
decreases as we move from b = 0.5 to b = 0.6 to b = 0.7. This finding is
reasonable even though it illustrates a counterintuitive case in which a
decision maker would prefer more variance to less.
In summary, the stochastic treatment of p shows that expected
disappointment levels drop as modal (the most frequent) true predic-
tive accuracy improves (moving rightward along each curve) and as
the upper limit (the best case), b, of the triangular distribution on true
FIGURE 5 E(Db) as a function of modal true predictive accuracy p
stochastic, triangular distribution [Colour figure can be viewed at
wileyonlinelibrary.com]
GRAVES AND RINGUEST
predictive accuracy increases (i.e., shifting downward among the three
curves). Our findings corroborate those of Ringuest and Graves
(2016): increases in the variance of the distribution on p may result
in an improved outcome for the decision maker, that is, a decrease
in expected disappointment.
4.4.2 | Comparison of deterministic and stochastic
treatment of true predictive accuracy
We now compare the results of our deterministic and stochastic treat-
ments to see what differences emerge. For the deterministic case, first
note the point in Figure 4 representing the “typical” VC's expected dis-
appointment, a Db value of 180%. Now, for the equivalent point in the
stochastic treatment, refer in Figure 5 to the leftmost point of the
middle curve (where b = 0.6 and c = 0.3). Because all calculations in
this figure are based on a = 0, the leftmost point of the middle curve
gives the E(Db) value for symmetric distribution where a = 0, b = 0.6,
and c = 0.3. So the designated point in Figure 5 gives the E(Db) value
equivalent to that in Figure 4 but simply takes the given p value and
places a symmetric distribution around it. For this particular point
and because the distribution on p is symmetric around the value
c = 0.3 (vs. a fixed value in the deterministic case of Figure 4), we
would expect to get an E(Db) value equal to the deterministic Db value
above, which we do, with Db = E(Db) = 180.18%.
The curves in both Figures 4 (deterministic) and 5 (stochastic) have
a negative slope, but the slope in Figure 4 is less steep (although, due to
scaling, this is not obvious in the graphs). This would indicate that as
true predictive accuracy (or modal true predictive accuracy) improves,
we see a faster decline in disappointment for the deterministic case.
This makes sense, because the effect of a one unit increase in modal
true predictive accuracy, c, is diluted by one‐third when we calculate
expected value, E(p) = (a + b + c)/3, in Equation (6). Furthermore, by
extrapolating the curves for the stochastic treatment in Figure 5, we will
note that—unlike the deterministic case—disappointment never goes
negative (for admissible values of c), so that Bell's elation never appears.
To summarize the comparative behavior of Bell's disappointment
under deterministic and stochastic conditions, we find that expected
disappointment decreases, ceteris paribus, as the variance of the dis-
tribution on p increases. This occurs because the increase in variance,
as we have modeled it, always corresponds to an increase in the best
case true predictive accuracy. We also find that as true predictive
accuracy increases with variance fixed, disappointment decreases
more slowly for the stochastic than for the deterministic case.
4.4.3 | Comparison of effects of BTA and CBO
overconfidence (stochastic treatment)
Table 3 shows BTA‐type expected disappointment levels typical for a
VC with characteristics similar to those observed in the Zacharakis and
Shepherd (2001) data. Conjectural predictive accuracy is fixed at its
estimated value, p’ = 0.66, whereas we allow c, the mode of true pre-
dictive accuracy, to range from 0.15 to 0.60, consistent with the
empirical estimates of Zacharakis and Shepherd (2001).
Table 4 shows the same analysis for CBO‐type expected disap-
pointment levels. In this case, the mode and upper limit are fixed,
whereas the lower limit, a, varies. Here again, conjectural predictive
accuracy is fixed at its empirically estimated value, p’ = 0.66. In this
GRAVES AND RINGUEST 599

TABLE 3 Disappointment due to better‐than‐average 5 years would see an average disappointment of about 180%. Those
overconfidence in the lowest, 10% in terms of predictive accuracy would sustain an
p’ a b c E(p) E(Db) average 5‐year disappointment of as much as 220%. On a 1‐year

0.66 0 0.6 0.15 0.250 225.50

basis, the typical VC should expect disappointment on the order of

0.66 0 0.6 0.2 0.267 216.33

25%. This may be compared with a typical disappointment of about

0.66 0 0.6 0.25 0.283 207.17

4.58% annually experienced by a market timer (compared with a

0.66 0 0.6 0.3 0.300 198.00

buy‐and‐hold investor) where both are investing in the S&P 500.

0.66 0 0.6 0.35 0.317 188.83

VCs then are predicted to experience disappointment levels five times

0.66 0 0.6 0.4 0.333 179.67

as high as market timing investors. It should be acknowledged, how-

0.66 0 0.6 0.45 0.350 170.50

ever, that the ratio of risky return to safe return for the VC is about

0.66 0 0.6 0.5 0.367 161.33

20, whereas in the case of the market timer, it is only about 5.0.

0.66 0 0.6 0.55 0.383 152.17

And, to be sure, the average VC would enjoy higher returns than the

0.66 0 0.6 0.6 0.400 143.00

market timer—just not as high as they anticipate.
When true predictive accuracy is modeled as a random variable,
our findings replicate those of Ringuest and Graves (2016). In general,
TABLE 4 Disappointment due to calibration‐based overconfidence
disappointment declines as the variance of true predictive accuracy
p’ a b c E(p) E(Db) increases, contrary to the usual case in which increases in variance
0.66 0.00 0.60 0.35 0.317 188.83 (uncertainty) result in worse outcomes for the decision maker.
0.66 0.05 0.60 0.35 0.333 179.67 We also find, that for VC's decisions, the two categories of over-
0.66 0.10 0.60 0.35 0.350 170.50 confidence examined in this study, BTA and CBO, have effects of the
0.66 0.15 0.60 0.35 0.367 161.33 same magnitude. Although Ringuest and Graves (2016) arrived at the
0.66 0.20 0.60 0.35 0.383 152.17 same conclusion, ours is the first study to incorporate empirical data
0.66 0.25 0.60 0.35 0.400 143.00 into an analysis of this issue.
0.66 0.30 0.60 0.35 0.417 133.83 In fact, the principal advance that this study provides is that all of
0.66 0.35 0.60 0.35 0.433 124.67 our findings are firmly grounded in empirical data.
The paper is limited, of course, by its assumptions, most particu-
larly, the assumption of a triangular distribution for true predictive
case, however, we have no empirical estimates regarding the investor
accuracy in the stochastic case. In future work, it may be of interest
beliefs about variance on true accuracy. Thus, we choose what we
to focus more closely on this probability distribution and perhaps
judge to be reasonable values, a = 0 to a = 0.35.
employ alternative distributions which may be more representative.
Now comparing our estimates of BTA‐induced expected disap-
Nonetheless, this work provides sound guidance to managers in
pointment in Table 3 to CBO‐induced expected disappointment in
venture capital and related fields. Informed by empirical data, our
Table 4, we note they are quite close in scale.
models makes a strong case for substantial disappointment.
The reader will undoubtedly note that some of the cases yield
identical values for E(Db). Compare, for example, Row 5 in Table 3 to
EN DNOTES
Row 1 in Table 4, both yielding E(Db) = 188.83%. This occurs because 1
Remarkably, the simple correlation between accuracy and confidence is
the parameters a, b, and c are identical for these two cases. It also 0.206, almost exactly the same as the typical value of 0.20 reported
occurs in succeeding rows. across a wide variety of decision realms in a review paper by Griffin
For reasonable values of a, b, and c, BTA disappointment for these and Varey (1996). As a caveat, however, note that Griffin and Carey's
value was a within‐subject estimate, whereas ours is a between‐subject
investors would typically run from about 140% to about 225%. For measure.
the same investors, CBO‐type disappointment would run from about 2
Allen, Dechow, Pope and Wu (2016) tested empirically for the presence
125% to a maximum of about 190%. of reference points and found significant reference dependence in
The superiority of the current comparative estimate of these two “bunching” of finishing times for marathon runners. This, they believe,
resulted from the aspirations of participants to finish below a given ½‐
types of overconfidence compared with Ringuest and Graves (2016)
hr mark.
is, of course, that ours are based on empirical data. In earlier research,
Deaves, Lüders, and Luo (2008) had found CBO to be a significantly
ORCID
more powerful influence (in increasing the pace of equity trading).
Samuel B. Graves http://orcid.org/0000-0001-9430-2613
But others, for example, Biais, Hilton, Mazurier, and Pouget (2005)
Jeffrey Ringuest http://orcid.org/0000-0003-1654-9551
found a weaker effect. Our conclusion is that their effects are compa-
rable in magnitude.
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How to cite this article: Graves SB, Ringuest J.
Overconfidence and disappointment in venture capital
decision making: An empirical examination. Manage Decis Econ.
2018;39:592–600. https://doi.org/10.1002/mde.2931