First you predict, then you take risks

Investors and corporate executives alike have to constantly do two things. First, they have to predict what is going to happen and then they have to take action that commits them to certain outcomes. Interestingly, a new study shows how the act of forecasting not only influences the actions taken with regard to these forecasts but also influences risk-taking in very different and unrelated tasks.

To see how this works, consider the lab experiment done in the study mentioned above. The researchers recruited a bunch of business students and asked them to first perform a series of forecasts. These forecasts were based on a series of numbers (e.g. 912 – 914 – 920 – 922 – 928 - ???) where participants had to forecast the missing number. Participants were given number sequences with different levels of difficulty (the example above is a simple one) but were not provided feedback on whether their answer was correct or not. Furthermore, some participants had to forecast relatively few number series, while others were tasked with forecasting a lot of them.

Then, once the forecasts were made, the participants were asked to perform a wholly unrelated task. In this task, the participants were presented with 25 parcels, and they could choose which ones they wanted to open. The participants were told that one of the 25 parcels contained a bomb and if they opened that one, they would not get paid at the end of the task. But for every parcel they opened that did not contain a bomb, they earned $0.80. Hence, the more risk-averse the participants were, the fewer parcels they would open.

Clearly, the prediction task has no impact on how well participants would do on the parcel task nor should it have any impact on how many parcels a participant chooses to open. Yet, what the study found was different.

People who had to forecast easier number sequences became more confident in their forecasting ability than people who had to forecast harder number sequences. And people who had to forecast more number sequences became more confident in their abilities if these number sequences were easy, but less confident if the number sequences were hard. Essentially, doing a lot of simple things increases our self-confidence while doing a lot of hard things impairs our self-confidence.

Impact of difficulty and quantity of forecasts on confidence

Source: Brown et al. (2023)

This increased confidence then led to more aggressive risk-taking in the parcel task. People who had to predict easier number sequences had higher self-confidence and opened more boxes. Meanwhile, people who had to predict harder number sequences opened fewer boxes. But unlike with self-confidence, the number of forecasts made only had a limited impact on risk-taking. Participants with low self-confidence after having to forecast harder number sequences did not reduce their risk-taking when forced to do more forecasts, but people with easier forecasting tasks increased their risk-taking when they had to provide more forecasts.

Impact of difficulty and quantity of forecasts on risk-taking

Source: Brown et al. (2023)

In the end, what that shows is that how much risk a person takes depends heavily on the circumstances they find themselves in at the moment. If they find themselves in a complex situation with lots of uncertainty, their self-confidence will wane, and they will become more risk-averse in general. If they find themselves in a relatively simple and seemingly predictable environment, their risk-taking will increase. And this is pretty much exactly what we observe in investors and corporate executives alike. If the world seems stable and things are on the up, risk-taking increases, but if the world is uncertain and things aren’t going according to plan, risk-taking drops. The results are the typical boom-bust cycles in markets and cycles of over- and underinvestment in business.