Behavioral Finance

Overconfidence, Investment Policy, and CEO Compensation

In the context of a capital budgeting problem, the authors show how and when a manager’s overconfidence can be beneficial to a firm. Risk-averse managers sometimes choose to stay away from risky projects that would increase firm value. Overconfident managers overestimate their personal ability to reduce risk, and as a result may make capital budgeting decisions that are in the better interest of shareholders. This benefit to the firm does not necessarily result in diminished welfare for the manager. First, when compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that provide him with better insurance. Second, since overconfident managers overvalue the product of their information acquisition efforts, their bias naturally commits them to exert effort. This reduction of moral hazard problems sometimes makes an overconfident manager hireable when an equally skilled but rational counterpart would not be considered. Still, too much overconfidence is detrimental to the manager as it leads him to accept highly convex compensation contracts that expose him to excessive risk.

Managerial Overconfidence and Corporate Policies

The authors present empirical evidence that managerial overconfidence is associated with aggressive corporate policies including investment, financing, financial reporting, and executive compensation. In particular, they collect five years worth of forecasts by Chief Financial Officers (CFOs) about stock market returns together with confidence intervals. CFOs are miscalibrated on average: realized returns are within respondents’ 80% confidence range only 39% of the time. Overconfidence (i.e., having a narrow confidence interval) is correlated with personal characteristics and is also stronger following periods of high returns in the market and in their firms. Firms with overconfident CFOs invest more, pay out fewer dividends, use debt more aggressively, engage in market timing, provide more managerial forecasts, and tilt executive compensation towards performance.