Do overconfi dent and over-optimistic entrepreneurs invest too much in their companies? Theory and evidence from Italian SMEs

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 over-optimism 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 over-optimism in determining entrepreneurs' portfolio allocations. We test the effect of the two latent variables – overconfidence and over-optimism – 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 over-optimism 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 over-optimism to overestimate expected returns. Using numerical examples, we show a more substantial role for overconfidence than over-optimism 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.