Week 3 - Hirshleifer, Low and Teoh (2012).

Question 1

What is the main idea of this paper?

Answer 1

• The authors try to investigate why firms hire overconfident CEOs.
• Overconfident CEOS have two possible effects on firms: either they accept good but risky projects, or they might undertake low payoff investments
• Bottom line is that overconfident managers are better innovators that can translate growth opportunities into firm value, but this only holds in innovative industries

Question 2

What are the two measures of overconfidence in this article?

Answer 2

1 Malmendier and Tate (2005) options exercise measure:
A manager who chooses to be exposed to the firm’s idiosyncratic risk is likely to be overconfident about the firm’s prospects.
Persistent over time (once overconfident, always overconfident).
61.08% of observations are classified as overconfident CEOs.

2 CEO portreyal in news media:
This measure counts the number of articles containing words related to overconfidence in proximity to the company name and the keyword “CEO.”

Question 3

What are the two proxies for innovation in this paper?

Answer 3

1.Innovation related investments (input):
- Level of R&D expenditures scaled by assets.
2. Innovation success (output):
- Number of patent applications.
- Total patent citations count.
- Time truncation bias: adjustments for technology class and year (if a manager is not so old,
it is likely that he/she will be less cited in news articles).

Question 4

Is there a casual effect of CEO overconfidence?

Answer 4

Potential interpretations:
1 Overconfidence causes managers to overestimate their prospects for success in risky endeavors such as innovation.
2 Firms with opportunities for innovative projects appoint overconfident CEOs.
Causality test:
Overconfidence is persistent, while firm growth opportunities vary over time.
Matching effects between CEO overconfidence and time-varying firm characteristics are likely to be strongest when the CEO is first appointed.
Eliminate years when manager is just appointed and reexamine relations.
Results:
Overconfidence continues to be positively related to volatility, R&D expenditures and innovative output.

Question 5

What are the conclusions of this paper?

Answer 5

The main puzzle to solve with this article: Why do firms employ overconfident managers and
give them leeway to follow their beliefs in making major investment and financing decisions?
-CEO overconfidence is associated with riskier projects, greater investment in innovation, and
greater innovation output.
- Greater innovative output (increase in patens) is achieved only in innovative industries.
- In innovative industries, overconfident CEOs are more effective at exploiting growth
opportunities and translating them into firm value.
Summarizing note: The effects of overconfidence on innovation are mainly found in
innovative industries, which suggest that the benefits of overconfidence for internal
innovative investments weigh especially heavily in industries in which firms have strong
internal innovative opportunities. In contrast, in industries that lack good opportunities for
internal innovation, overconfident CEOs may be more likely to resort to bad acquisitions.