Why optimism and entrepreneurship are not always a good mix for business

Most business start-ups end badly. While the number of new businesses created in the UK in 2016 – 414,000 – looks impressive at first, it is less so when set against the number that failed that same year: 328,000.

Failure has always been the hallmark of entrepreneurship – only around 50% of businesses survive their first five years. And not only are the chances of survival slim, but there is evidence that on average business owners earn less than if they had remained as someone else’s employee. They also work substantially longer hours than their counterparts in paid employment.

So what sort of person decides to leave the relative security and comfort of employment and invest on average 70% of their wealth on the high risk lottery ticket that is entrepreneurship? And in such large numbers? The answer: optimists.

Sure, the potential returns from founding a successful business and becoming the next Bill Gates may be so great that the gamble is possibly worthwhile. Or perhaps the attraction of “being our own boss”, is part of the attraction. But a dash of optimism is a powerful catalyst to action.

Psychologists have long documented our tendency to be optimistic. In fact, optimism is one of the most pervasive human traits. By optimism, we mean a tendency to overestimate the probability of doing well (or conversely, underestimating the probability of failure).

For instance, most people overestimate their driving ability, their future financial prosperity, and their chances of a successful, happy marriage. Across many different methods and domains, studies consistently report that a large majority of the population (about 80% according to most estimates) display an overly optimistic outlook.

Viewing ourselves and our chances of future success in implausibly positive ways may increase ambition and persistence. It may persuade others to cooperate with us. There may even be an element of self-fulfilling prophecy, whereby exaggerated beliefs increase the probability of success.

Nevertheless, there is a downside. As it is better to use correct information when making choices, optimism tends to result in faulty assessments and mistaken decisions. Yes, it may well enhance our performance but it also results in participation in activities doomed to fail.

In our research, we examine how these forces play out in business start-ups – a big decision involving much uncertainty. Previous studies have documented that optimistic thinking tends to be highest when outcomes are uncertain. It also flourishes when success is perceived to be under the individual’s control.

So it is no surprise that optimists are attracted to the uncertain and turbulent world of entrepreneurship. The greater an individual’s optimism, the more likely they have been fooled into thinking they have found a good business opportunity and that they have what it takes to exploit it successfully. Every episode of the BBC’s Dragons Den provides examples of such delusional thinking. Realists and pessimists are less likely to proceed with unpromising prospects.

Our findings provide evidence that higher optimism is indeed associated with lower entrepreneurial earnings. Optimism is measured as bias in forecasting personal financial outcomes when subjects are still in paid employment, prior to beginning their entrepreneurial adventure.

The downside of optimism

Allowing for earnings while an employee, we find that business owners with above average optimism earn some 30% less than those with below average optimism – suggesting they would have been better off if they had made the prudent choice of remaining an employee.

Marriage is in some ways like starting a business. As a further test of whether optimism leads to rash decisions, we found that optimists are more likely to divorce.

Overall, our results suggest that many entrepreneurial decisions can be viewed as mistakes, based upon an excessive belief in the probability of doing well. Too many people are starting business ventures, at least as far as private returns are concerned.

It seems likely that optimism is partly responsible for the sizeable churn of business births and deaths that happen year on year around the world. Governments should therefore be cautious in adopting policies that encourage start-ups – it seems people need little encouragement as it is.

And while it is true that new businesses create new jobs, it should also be noted that when start-ups fail, they are responsible for a great deal of job destruction and heartache.