Week 3 - Overconfidence

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.

Question 2

What are the two manifestations of overconfidence?

Answer 2

1 Miscalibration (overprecision).
2 Better than the average effect.

Question 3

What is miscalibration, and what are the resons for it?

Answer 3

Miscalibration or overprecision is defined as excessive confidence about having accurate information

Agents overestimate the precision of their forecasts.
Agents underestimate the volatility of random processes.
Agents underestimate the range of potential outcomes.

Question 4

What is the better-than-average effect and what can it translate into?

Answer 4

When individuals assess their relative skill, they tend to overstate their acumen relative to the average.
Are you a better driver than the average driver? In a typical survey, over 80% of respondents think so.
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 5

What are the differences between miscalibration and optimism?

Answer 5

Optimistic investors overestimate the mean of their firm cash flows.
Miscalibrated investors underestimate the volatility of their firm future cash flows.
E.g. What is your expectation about the EPS next year of your firm?

Question 6

What are the reasons for investment distortions?

Answer 6

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.
3 CEO overconfidence and corporate policies:
Alternative explanation of corporate investment distortions. Decisions by managers with biased views about their company (projects) can result in both overinvestment and underinvestment.

Question 7

What is the dark side of managerial overconfidence?

Answer 7

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.