Believe in yourself, for my benefit.

In his Stanford CS183 class on tech startups, Peter Thiel asks the age-old question: Do entrepreneurs succeed because of skill, or because of luck?

He also gives the correct answer: Since every new company is different, we can't do statistical analysis to predict a startup's success or failure from past data (in econometrics jargon, startup success is non-ergodic). We know for sure that some skill is involved in the mix; we also know for sure that some luck is involved in the mix. How much skill and how much luck, though, is something we'll never really know.

So here's the question: Should a prospective entrepreneur believe in skill, or luck? And my answer is: Depends on who's asking! From an individual standpoint, it could go either way. But there are reasons to think that even if belief in skill is wrong, it might benefit society! Here's why.

If you believe in skill, you're more likely to be an entrepreneur, because you'll be more convinced that you can beat the market. Which is to say, a person who believes she is more skilled than the average will only bet on that belief if she thinks skill matters. If you think entrepreneurial success is mostly just down to luck, then what you should do (as Thiel points out) is to diversify your portfolio and manage your risk. Go get a nice stable high-income job and put your savings into index funds. I.e., don't be an entrepreneur at all.

This fits with economic theory. Economist Frank Knight famously described a difference between "risk" and "uncertainty". Risk is when you don't know the outcome, but you know the probabilities of the outcomes (e.g. flipping a coin). Uncertainty is when you don't even know the probabilities of success and failure (e.g. starting the first social-networking company). Entrepreneurs, he said, must accept not just risk, but also true uncertainty, since no one really knows how likely a new business is to succeed. This is especially true of tech entrepreneurs.

If you believe in skill (and if you have skill), you are more likely to accept true uncertainty, because you probably think that your guess regarding your probability of success is better than other people's guess. In other words, you believe that your knowledge of your own skill is inside information, so instead of diversifying your portfolio (i.e. insuring against risk), you concentrate your investments in one big bet on your inside info.

So will believing in skill be good or bad for you? It's tough to know. In some eras, there are lots of good opportunities just out there for the taking (e.g. when the internet was just being invented), but in other eras, the available ideas are more scarce, and you just never know which era you're in (it also differs by sector).

But some people argue that even when believing in your own skill is a bad bet from an individual standpoint, it might be good for society to have lots of people who believe (even irrationally!) in their own skill. The reason, essentially, is this: There is always new stuff out there, and if society is going to progress, somebody needs to discover it. If nobody is confident in their own skill, nobody will try any new stuff; each person will limit her exposure to true uncertainty, but society will suffer. In other words, there is a positive externality to exposing oneself to true uncertainty.

Blogger and CTO Matt Sherman puts it this way:

The process of going from nothing to something...is inherently irrational...To embark on it is to leave the world of economic modeling...[P]rogress requires madness, that is, the freedom to pursue choices whose rationality can’t be measured.

Economists Antonio Bernardo and Ivo Welch actually have a model that describes how this could happen. From the abstract to their paper:

By ignoring the herd, the actions of overconfident individuals ("entrepreneurs") convey their private information. However, entrepreneurs make mistakes and thus die more frequently. The socially optimal proportion of entrepreneurs trades off the positive information externality against high attrition rates of entrepreneurs[.]

Same basic idea!

So there are theoretical reasons to believe that overconfident entrepreneurs are more likely to benefit society than they are to benefit themselves. If you try to be the next Mark Zuckerberg, chances are you're taking on a lot more risk than you would take if you weren't such an overconfident nut. But without overconfident nuts like you, our economy will be poorer and our society will be more stagnant.

So, by all means, young entrepreneur, believe in skill! Believe that you, not the person sitting next to you, will be the next tech billionaire. You're probably wrong. But the chance that you might be right is enough to make your quixotic madcap adventure worth it for the rest of us.