Behavioral CEOs: The role of managerial overconfidence. (2015)

“Overconfident CEOs  have a higher tendency to undertake mergers… overestimate future earnings… borrow more aggressively against future earnings to avoid missing current earnings forecasts …”

Ulrike Malmendier, Haas School of Business and University of California, Berkeley. Geoffrey Tate, University of North Carolina
Journal of Economic Perspectives, 29(4): 37-60.

This paper “provides a theoretical and empirical framework for synthesizing and assessing the burgeoning literature on CEO overconfidence.”

The authors provide “novel empirical evidence” that overconfidence matters for corporate investment decisions, delivering it in a framework that “explicitly addresses the endogeneity of firms’ financing constraints.”

Some of the authors’ findings include:

…the relation between investment and the interaction of various overconfidence measures with cash flow is estimated to be significantly positive, implying a significantly higher sensitivity of investment to internal resources among overconfident CEOs than among rational peers

… overconfident CEOs also tend to have a higher tendency to undertake mergers and, particularly, diversifying deals, especially if they have access to internal financing

… Because overconfident CEOs overestimate future earnings, they borrow more aggressively against future earnings to avoid missing current earnings forecasts and generally practice less-conservative accounting practices

… another strand of this work finds evidence of a “bright side” to overconfidence… finding that overconfidence is generally beneficial for a firm’s innovation performance, and especially so in competitive and innovative industries.

… firms choose overconfident CEOs at times when the predictable consequences of overconfidence on policies – like high levels of investment given abundant internal funds – are likely to benefit the firm. The authors provide evidence that overconfident senior executives are indeed more likely to be selected as CEOs and that they tend to enhance firm performance during the period when there is a change in strategy for more mature firms.

Access the full paper here: Behavioral CEOs