Entrepreneurship is not irrational

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Entrepreneurship is not irrational

Are entrepreneurs crazy? The question has certainly been asked. The costs of the start-up life can seem insanely high. You give up your salary and benefits and find yourself eating delivery pizza and living with roommates into your 30s. You never have a day off. You will live with the constant risk that everything could come crashing down around you, leaving you with no job, no income and a black mark on your resume.

Economists have long believed that these costs are too high for a person who is both normal and rational. Barton Hamilton of Washington University found in 2000 that the median earnings of an entrepreneur were 35 percent less than the median salaried worker. A team of University of Chicago economists found in 2002 that the financial return to entrepreneurship is no better, on average, than the return from putting your money in the stock market.

This makes the decision to start a business look a little irrational. Entrepreneurs seem to be getting lower average returns with much higher risk - something that economics says that normal, rational people never do.

There have been many attempted explanations for why people might launch themselves into a start-up career despite these dismal average results. They might be irrational, overestimating their own chances of success. They might be lured by the small chance of a huge payoff, like a lottery ticket. They might simply love the lifestyle of running a business. Or they might be driven to find out if their pet idea really has legs.

These things might all be true, especially of the type of people who chose entrepreneurship. But a professor at University of California-Berkeley’s Haas School of Business has found another factor that may have been largely overlooked until now. Gustavo Manso realized that the payoff of entrepreneurship goes beyond the chance that your business will succeed. Starting a business is a form of experimentation that can boost your prospects later in life, even if the business fails.

In his paper, Manso considered not just the current situations of entrepreneurs versus salaried workers, but their lifetime earnings. This is an important distinction, because most of the entrepreneurs we see at any point in time are simply experimenting with their new ideas. If the idea fails, they go back to a regular job, having lost only a few years of higher salary. If the venture succeeds, they can make a lot. In terms of lifetime earnings, that might not be such a bad gamble.

To test this idea, Manso needed data that tracked the same sample over different points in time. He got it from the 1979 National Longitudinal Survey of Youth, which followed young people for about three decades. Comparing the lifetime earnings of entrepreneurs and salaried workers, he found that entrepreneurs actually make more, on average. Sure enough, self-employment tends to last only a short time, maybe two years
on average - people who fail get out quickly.

What’s more, Manso finds that entrepreneurs experience only slightly higher lifetime earnings variance - that is, risk - than people who go the salaried route. In other words, the lifetime risk-return tradeoff of starting a business looks pretty attractive after all.

Of course, Manso’s data doesn’t distinguish between types of entrepreneurship - someone who starts a corner store is treated the same as someone trying to launch the next Uber. So we still don’t know whether the high-octane venture-capital-funded start-up lifestyle that has become so celebrated in the media is a good economic bet or not. But Manso’s analysis has at least given us a better tool for making that calculation.

So if entrepreneurship actually offers a better return than the salaried life, why don’t more people do it? The answer probably lies in human psychology. In most risky decisions - stock investments, career choices - you have at least some idea of the chances of success and failure. But when you try to create a new business, you don’t really know how likely you are to succeed. When Bill Gates dropped out of Harvard to start a software company, he didn’t know whether his decision was a near-certain moneymaker or a long shot.

Psychologists and economists find that many people instinctively shy away from that sort of ambiguity. Only a few love it. These may be exactly the sort of people who become entrepreneurs - people whose battle cry, in the immortal words of Han Solo, is “Never tell me the odds!”

The author is an assistant professor of finance at Stony Brook University.

by Noah Smith

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