We argue that overconfidence wrongly inflates the expected returns to a risky income-generating activity. Overconfidence thus increases the willingness to take risks. We test this prediction using a sample of smallholder farmers from Ethiopia who face a risk-return trade-off in their crop cultivation choices. To meet their subsistence needs, these risk-averse farmers arguably have large incentives to wisely manage their risks. We find that overconfident farmers cultivate riskier crop portfolios. The relationship between overconfidence and risk taking is more pronounced for farmers who live near markets or are net sellers. Our results are robust to the inclusion of a wide range of controls (including local fixed effects, use of risk-managing measures, experience of idiosyncratic shocks, socioeconomic characteristics, measures of risk aversion, and personality traits) and instrumental variable estimation. The high volatility of agricultural income may thus not only be the result of a risky environment but also of farmers’ individual psychological biases.
Bibliographical noteFunding Information:
We owe special gratitude to Gebrehiwot Ageba for his invaluable support in the design and implementation of the survey. We thank the editor, Marcel Fafchamps, and two anonymous referees for excellent comments. We are grateful to Justin Sydnor for helpful comments on an earlier draft. We also thank conference/seminar participants in Berlin, Hamburg, Kiel, and Munich for discussions. We acknowledge financial support from the Foundation Fiat Panis. All remaining errors are ours. Contact the corresponding author, Toman Barsbai, at firstname.lastname@example.org.
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- ECON Applied Economics
- Risk-return tradeof
- portfolio choice
- expected returns
- covariate shocks
- psychological bias
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