CEO overconfidence and corporate investments

Question 1

What is overconfidence?

Answer 1

Overconfidence is a behavioral bias that causes people to overestimate the accuracy of their information as well as their ability relative to a reference group.
Manifestations of overconfidence:
1) Miscalibration.
2) Better than the average effect.

Question 2

Define miscalibration

Answer 2

Miscalibration or overprecision is defined as the excessive confidence about having accurate information.
Reasons for miscalibration: Agents
1) Overestimate the precision of their forecasts,
2) Underestimate the volatility of random processes, 3) Underestimate the range of potential outcomes.

Question 3

Define - better than the average effect

Answer 3

The better than the average effect describes agents who believe that they are better than a reference group with respect to a particular ability or skill.
Better than the average effect can translate into
Optimism about future prospects that are related to own performance.
Illusion of control - agents overestimate their ability to control events over which they have limited influence

Question 4

What are the origins of overconfidence?

Answer 4

1)Evolutionary biology
2)Self-attribution bias:
Tendency to ascribe success in some activity to own skill, while blaming failure on bad luck or the actions of others.
Langer and Roth (1975): Subjects asked to predict coin tossing outcomes. Those with early successes, considered themselves skilled in predicting tosses.
3) Availability bias: When judging the probability of an event people search their memories for relevant information, which may not be representative (e.g., only successful traders appear in financial media).

Question 5

Are managers more overconfident than general population?

Answer 5

Yes,

1) Selection effects: Overconfident agents
2) Job characteristics: Psychological evidence suggests that overconfidence is high

Question 6

How to measure miscalibration?

Answer 6

Survey elicits information about CFO’s subjective distribution of future returns: Point forecast – subjective mean (optimism),
Confidence interval – subjective dispersion (miscalibration).

where z is the number of standard deviations within the confidence interval. Z equal 2.65 for 80% confidence intervals in a normal distribution.

Question 7

Are CFOs miscalibrated?

Answer 7

Yes,O nly 36% of S&P500 realizations fall within predicted 80% confidence interval.

CFOs cannot predict returns: No significant relation between S&P 500 future one-year realized returns and CFO point forecasts.

Question 8

Does miscalibration affect corporate planning and forecasting?

Answer 8

Miscalibration stronger in periods with high market volatility (above median VIX) eventhough confidence intervals do widen.

Miscalibration varies over time: Confidence bounds are wider in high volatility periods, but calibration does not improve.

Miscalibration varies with forecast horizon and is less severe for long-term forecasts (10-year returns).

Education and age have a positive effect on long term miscalibration, but no relation with short term miscalibration.

Question 9

What is the effect of miscalibration on corporate investments and leverage?

Answer 9

CFO miscalibration affects corporate decision making inducing riskier strategies (higher investment and leverage).

Implications for investors, regulators, and other stakeholders who rely on corporate data and forecasts as well as corporate governance.

Question 10

Do miscalibrated CFOs choose high investment and leverage or does high investment and leverage induce selection and cause executives to be overprecise? (causal effect)

Answer 10

Investment intensity seems to increase when miscalibrated new CFO is hired.

Question 11

What are the implications of better-than-average effect?

Answer 11

• CEOs overinvest if they have sufficient internal funds and are not disciplined by the capital market or corporate governance mechanisms.
• They are reluctant to issue new equity, and, hence, invest less (possibly even underinvest) if internal funds are insufficient.

Question 12

Alternative explanations of investment-cash flow sensitivity:

Answer 12

1 Agency view - misalignment of managerial and shareholders objectives:
Managers overinvest to reap private benefits such as perks, large empires, and entrenchment. The overinvestment amount depends on the influx of cash flow (free-cash-flow problem).
2 Asymmetric information between insiders and the capital market:
When company share are undervalued, the managers (who act in the interest of shareholders) restrict external financing in order to avoid diluting the shares. Increases in cash flow can reduce the underinvestment distortion.

Question 13

Overconfidence measure for Tate (2005)

Answer 13

“Revealed beliefs” measure of CEO overconfidence based on their personal portfolio decisions:
High exposure to idiosyncratic risk of their firms.
Risk-aversion and underdiversification predict that CEOs should divest company stock-price risk.
Overconfident CEOs believe that stock prices under their leadership will rise more than they objectively should expect.
They postpone option exercise or even buy additional company stock.

Question 14

Alternative interpretations of the measures (why managers hold longer the shares given to them)?

Answer 14

1. Inside (private) information:
   - Positive information likely is transitory, overconfidence is persistent.
   - Predicts switches between early and late exercise not reflected in data.
   - CEOs also do not gain positive abnormal returns form holding option or stocks.
2. Signaling positive prospects to market:
   - Does not predict investment-cash flow sensitivity.
   - Stock-based (net buyer) measure computed “out of sample.”
3. Risk tolerance (lower risk aversion):
   - Less risk averse CEOs should borrow more and be less sensitive to cash flows. - Does not explain net buyer measure.
4. Tax reasons.
5. Procrastination:
   - CEOs trade on their personal portfolios.
   - Inertia does not predict purchasing additional stocks (net buyer).

Question 15

What are the conclusions of Malmendier and Tate (2008)?

Answer 15

Overconfident CEOs make value-destroying mergers:
1 Overconfident CEOs are 65% more likely to make an acquisition.
2 They do more mergers that are likely to destroy value (diversifying mergers).
3 Overconfident CEOs do more mergers when they have access to internal financing.
4 The market reaction is significantly more negative for mergers announced by overconfident CEOs.

Question 16

Conclusion: Dark sides of managerial overconfidence

Answer 16

Overconfidence can cause managers to: Produce miscalibrated forecasts,
Overestimate returns to investment projects, View external funds as overly costly.
Biased views about their company (projects) can induce investment distortions: Conduct value-destroying mergers.
Implement projects with excessive risk or negative NPV.
Shun profitable positive NPV projects when internal funds are scarce.
All these problems, while overconfident CEOs believe that they act in the best interest of their shareholders → Governance implications:
“Immune” to standard incentives such as stock-based compensation. Respond to capital structure (motivates “debt overhang”).
Need for more involvement of independent directors.

Question 17

Why firms employ overconfident managers and give them leeway to follow their biased beliefs in making major investment and financing decisions?

Answer 17

1. Overconfident CEOs are better innovators: Overconfidence associated with greater investment in innovation, and greater innovation output (number and citation of patents) per unit of investment.
2. Greater efficiency of innovation is achieved only in innovative industries.
3. In innovative industries, overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value.

Question 18

What are the bright and dark side of overconfident manager?

Answer 18

Corporate investment and managerial overconfidence:
Dark sides - investment distortions relative to rational manager benchmark, e.g.,
more value destroying mergers.
Bright side - may counteract distortions due to other managerial characteristics or agency problems, e.g., greater innovation.