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CEO overconfidence and corporate investment. (2005)

“..studied how hubris affects CEOs’ corporate investment decisions … CEOs tend to think that under their glorious leadership the stock prices will keep going up, so they keep holding on to their shares and their options.”

 

Malmendier, U., Stanford University
Tate, G., University of Pennsylvania

Journal of Finance 60: 2661-2700.

Overconfident CEOs who overestimate their ability to generate value within their company systematically make distorted decisions about when, how, and how much to invest in new projects.

Malmendier and Tate studied how hubris affects CEOs’ corporate investment decisions. They studied the tendency of a CEO to overly invest in his or her own company by habitually buying its stock or by holding on to stock options long beyond the point when they should be exercised. “These CEOs tend to think that under their glorious leadership the stock prices will keep going up, so they keep holding on to their shares and their options.”

They found that overconfident CEOs think their investment projects are greater than they actually are. They don’t want to go to the outside equity market and issue more shares for their projects because they think the market will unfairly undervalue the stock. Often, however, the market is in fact accurately perceiving the reality of the situation, it’s just that the CEO is overly optimistic.

These CEOs therefore tend to rely on their own available funds for growth and expansion projects. They end up making investment decisions not on the quality of their projects—which is what a wise leader would do—but rather on how much cash flow they have available.

Access the full paper here: CEO overconfidence and corporate investment

 

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