Picture a CEO who is charismatic, possesses great confidence and certainty, and is a natural leader. Things have generally come easy for this person and so he or she is not prone to worrying or self-doubt. This is an executive graced with natural charm who climbed the ladder by pleasing superiors, shepherding subordinates and believing in him or herself. But is this person prepared for the top job?

In the context of this discussion, it is helpful to understand the Dunning-Kruger effect, a theory about individuals who overestimate their own abilities. Critics of our current president have cited this concept of psychology in trying to understand his psyche, but I would like to consider it for a discussion on business leadership.

David Dunning and Justin Kruger were two psychologists who tested the cognitive bias of illusory superiority on the undergraduate students in an introductory course of psychology. Students were asked to estimate their rank in the psychology class. The group of competent students underestimated their class ranks, while the group of incompetent students overestimated their class ranks. The individuals with the greatest aptitude — those right to be confident — were actually the least sure of their abilities, while those with less competence were the most self-assured.

The pitfalls of overconfident CEOs not recognizing their own or their organization’s weaknesses were clearly demonstrated in the financial crisis. Adobe Stock

In banking or any business, confidence tends to be rewarded, while indecision can lead to a slippery slope. But this means that any business faces the risk of elevating confident leaders with an overestimation of their abilities, while passing over the most competent candidates.

The philosopher Bertrand Russell, who was writing before Dunning and Kruger, formulated it this way: "One of the painful things about our time is that those who feel certainty are stupid and those with any imagination and understanding are filled with doubt and indecision."

So who do we pick as our leaders? Those who demonstrate uncertainty and doubt, who go and seek advice from those they consider smarter than they? Not in all cases, certainly. But leaders able to project confidence while at the same time taking time to consult and get advice, so that they do not simply follow the market momentum but are able to make strategic pauses and pivots, are not always easy to find. It requires a high level of self-awareness to enable the CEO to address his/her own personal weaknesses, as well as those of the company.

Yet, while knowing one’s own personal weaknesses is important, it is not sufficient to be successful. One also has to understand the rules of the game being played and the fitness of the organization to play the game. This is in itself an important measure of competence, but, according to Dunning and Kruger, those who do not understand those rules may not realize that they do not understand. Paradoxically, those who do may give the impression that they do not.

The pitfalls of not recognizing an organization’s weaknesses as well as not addressing those shortcomings were clearly demonstrated in the financial crisis. From 2003 to 2007, investment banking and other financial services were on a roll, and CEOs did not ask many questions about the surfeit of profits flowing from mortgage securitization and other ventures. In some ways, this paralleled the success of investments in Bernie Madoff funds — tough questions are not asked when the profits flow.

Citigroup’s CEO at the time, Charles Prince, when interviewed by the Financial Times in July 2007, summed up the spirit of financial markets. Referring to the ample liquidity in the market for leveraged buyouts, he famously said, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (At the time, some feared the brewing subprime lending crisis would drain market liquidity.)

By July 2007, however, the wheels were starting to come off, most notably with the collapse of the Bear Stearns High Grade Structured Credit hedge fund. Did Prince, the Bear Stearns fund managers, and other CEOs pushing to get into the field of mortgage securities and other complex instruments simply not understand the game they were playing? These leaders were making confident statements to their investors that were well received about the strength of the market in the years leading up to the crisis. Did this reflect the Dunning-Kruger effect in action?

There were leaders and traders who did not show such confidence in the market. John Paulson, the hedge fund manager, was one example. A perceived lack of confidence, of course, should be identified as a sign of competence rather than the opposite. Ultimately, investors who understood that were rewarded. Echoes of this dynamic can be traced back to the dot com bubble of the late nineties. The brash and confident pronouncements of analysts such as Henry Blodget were treated as rock-star truths, while doubters were vanquished. Whose pronouncements were proven correct, ultimately? These are examples of crises of overconfidence, precipitated by unjustified runs of success and, possibly, a Dunning-Kruger-like overestimation of one’s abilities. In 2008, multiple CEOs failed to honestly and accurately appraise their companies’ abilities to manage huge piles of complex mortgage-linked securities, resulting in several high-profile failures.

Sometimes an overconfident leader can get in trouble presuming that the rules of the game are the same in every company and ever sector.

Switching companies can be hazardous for a leader who does not understand fully how the rules may change depending on which company you work for. Jon Corzine, for example, had been a star fixed-income trader at Goldman Sachs and then senior partner, when, after a short career in politics, he moved to the CEO position at MF Global. Corzine, interviewed in 2010 by The New York Times, commented, ''I wouldn't have come here if I thought MF Global were going to be the same company in five or 10 years,'' adding, ''We have to find other ways of building revenue.''

As good as his word, Corzine, pursued an aggressive trading strategy to grow revenue including trading in European distressed sovereign debt. But clearly MF Global was no Goldman Sachs and Corzine at MF Global was different from Corzine at Goldman Sachs. MF Global was eventually forced to close in 2012 after some of its large trading bets did not work out. At a firm like Goldman, the infrastructure, culture and risk management capabilities have a bigger impact than, and can serve as an effective counterbalance for, individual traders’ perceived brilliance and sometimes overreaching ideas and strategies. An individual trader may discount the strengths of an established organization compared to his or her own perceived abilities. But chalking up their successes solely to individual brilliance is probably likely to be a form of Dunning-Kruger. Disaster will surely follow.

Effective leaders don’t have to know everything about the organizations they run. But they have to be willing to listen and learn on the job.

For example, when he became CEO at Morgan Stanley, James Gorman did not come from the traditional core business areas of the investment bank, such as fixed income trading, unlike his popular predecessor, John Mack. Gorman lacked that pedigree, but still projected confidence to employees, investors and other key stakeholders. Gorman, however, has not been afraid to appoint and consult with smart senior executives and develop a deep understanding of the company’s strengths and weaknesses. He hit the pause button on the type of complex securities that almost led to Morgan Stanley’s downfall in 2008. At the same time, he has invested in more reliable and simple to understand sources of revenue such as wealth management. On the face of it, Gorman appears to be a good example of confident — but not overconfident — competence. Many would also put JPMorgan Chase CEO Jamie Dimon and current Goldman CEO Lloyd Blankfein in that camp.

Of course, since projecting confidence is part of the CEO’s job description, it is often hard to distinguish between the confident and competent, and the confident and incompetent. Studying the habits of the leader, however, should provide enough hints to draw solid conclusions. Is the leader in question ever willing to admit he or she is wrong or has room to improve as a leader? Can the leader admit that the institution has room to improve under his/her leadership? Is the leader willing to learn to fill in knowledge gaps, and ask for time and further discussion before making potentially critical strategic decisions? Does the leader have an awareness to know when a decision is potentially critical or influential for the future direction and fortune of the organization?

A CEO or leader that fails to exhibit these characteristics very likely suffers from a crisis of overconfidence mixed with a good measure of incompetence. That is why it is critical to ensure that the same compliance and risk guidelines and checks are applied to the CEO and leaders as every other employee at the firm. It is also important to maintain careful oversight and regulation of the potentially risky paths that doubt-free leaders can sometimes take. The proprietary trading ban in the Dodd-Frank Act, known as the Volcker Rule, is a step in that direction. Other than that, it might be a good idea to start to look for an early replacement.

Andrew Waxman

Andrew Waxman

Andrew Waxman is an associate partner in IBM Global Business Services' financial markets risk and compliance practice. He is the author of the book "Rogues of Wall Street: How to Manage Risk in the Cognitive Era."

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