Does Overconfidence Affect Corporate Investment? CEO Overconfidence Measures Revisited

Summary:

This article presents the growing research area of Behavioral Corporate Finance in the context of one specific example: distortions in corporate investment due to CEO overconfidence. We first review the relevant psychology and experimental evidence on overconfidence. We then summaries the results of Malmendier and Tate (2005a) on the impact of overconfidence on corporate investment. We present supplementary evidence on the relationship between CEOs’ press portrayals and overconfident investment decisions.

This alternative approach to measuring overconfidence, developed in Malmendier and Tate (2005b), relies on the perception of outsiders rather than the CEO’s own actions. The robustness of the results across such diverse proxies jointly corroborates previous findings and suggests new avenues to measuring executive overconfidence.

Keywords are behavioral corporate finance, CEO overconfidence & corporate investment.

The literature in behavioral economics and behavioral finance departs from the traditional economic model to incorporate psychological evidence on non-standard preferences and beliefs, such as loss aversion, sunk-cost fallacy, or overconfidence. As economists we are interested in market interactions. In the market, high-stake incentives and repeated transactions might discipline overconfidence is to construct a plausible measure of overconfidence. Biased beliefs naturally defy direct and precise measurement. In our previous work, we propose two approaches. The first is a ‘revealed beliefs’ argument. We infer CEOs’ beliefs about the future performance of their company from their personal portfolio transactions. The second approach captures how outsiders perceive the CEO.deviations. The analysis of overconfidence relates several branches of the psychology literature. First, an extensive experimental literature documents the tendency of individuals to consider themselves ‘above average’ on positive characteristics. The better than average effect also affects the attribution of causality. Because individuals expect their behavior to produce success, they attribute outcomes to their actions when they succeed and to bad luck when they fail. This self-serving attribution of outcomes reinforces overconfidence. The biggest challenge for the analysis of overconfidence. While overconfidence about the firm’s projects may be less likely in external board members. Another important issue is the selection of board members.
http://eml.berkeley.edu/~ulrike/Papers/07_eufm_006.pdf