No such thing as risky business for entrepreneurs

New business owners actually avoid risks as much as anyone, it's overconfidence that makes them take the leap

Ask most people how entrepreneurs are different from the rest of the population, and you’re likely to hear: “Entrepreneurs are risk-takers.”

Not so, says Anne Marie Knott, assistant professor of strategy at the Olin School of Business at Washington University in St. Louis. Entrepreneurs are just as sensitive to uncertainty as anyone. In fact, several studies suggest that entrepreneurs are more risk-averse than other people. So why do they risk losing their shirts by starting a business? They have an overdeveloped sense of confidence that that they can beat the odds, Knott says.

“There are two dimensions of uncertainty,” Knott says. “There are things that the entrepreneur cannot control, such as floods or the economy. We call that market-demand uncertainty. Then there are things they think they can control, such as their skills and business acumen, and that’s called ability uncertainty.”

Considering these two dimensions, a pattern emerges of when an entrepreneur will or won’t enter a market, Knott says. If market demand is highly uncertain — if there’s a great deal of fluctuation in the market — and the entrepreneur’s uncertainty of his or her ability is low, the entrepreneur will perceive the situation as too risky and not embark on a new venture. As we would expect, when demand uncertainty is low and ability uncertainty is high, then the situation is ripe to start a business. However, Knott says, when the entrepreneur faces conditions of high market uncertainty coupled with high ability uncertainty (overconfidence), he or she will enter markets they would ordinarily avoid

“We all have dimensions in which we think we excel — and we all tend to exaggerate how much we excel,” says Knott. “There’s one study which found that 60 percent of high-school seniors believe they are in the top 10 percent in their ability to get along with others, and 25 percent think they are in the top 1 percent. With entrepreneurs, they think they’re better than average at dealing with the uncertainties of running a business.

“So it’s not that entrepreneurs are greater risk-takers than the rest of the population, it’s that they do not view the business situation as being risky. Instead, they believe that their skill and knowledge is above average and therefore they can succeed where others might fail.”

Knott and Brian Wu of the Wharton School at the University of Pennsylvania, drew their conclusions after studying 14 years of the banking industry. Banking has a low rate of entry and is subject to a cyclical business cycle. The industry is no more risky than other businesses; it has a turnover rate of 3 percent on average compared with 10 percent in the rest of the economy. What made the banking industry ideal for this study is that there are 50 different bank markets, so the researchers could keep everything else constant and just examine changes in demand uncertainty and ability uncertainty

“Entrepreneurs aren’t different from other people,” Knott says. “They’re willing to take on the huge risk tying up all their capital in a business and foregoing business not because they’re bigger risk-takers, but because their tendency toward optimism compensates for uncertain market demand.”

The findings of the study are published in issue 52 (9) of Management Science.

Editor’s Note: Professor Knott is available for interviews. Television and radio reporters can conduct live or taped interviews via the University Communication’s studio, which is equipped with VYVX and ISDN line.