We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash f low, particularly in equity-dependent firms.IN THIS PAPER, WE ARGUE THAT PERSONAL characteristics of CEOs in large corporations lead to distortions in corporate investment policies. In particular, we study the investment decisions of CEOs who overestimate the future returns of their companies, measured by a failure to divest company-specific risk on their personal accounts. We find that overconfident CEOs have a heightened sensitivity of corporate investment to cash f low, particularly among equity-dependent firms.The two traditional explanations for investment distortions are the misalignment of managerial and shareholders interests (Jensen and Meckling (1976);Jensen (1986)) and asymmetric information between corporate insiders and the capital market (Myers and Majluf (1984)). Both cause investment to be sensitive to the amount of cash in the firm. Under the agency view, managers overinvest to reap private benefits such as "perks," large empires, and entrenchment. * Ulrike Malmendier is at Stanford University and Geoffrey Tate is at the University of Pennsylvania. We are indebted to Brian Hall and David Yermack for providing us with the data. We are very grateful to Jeremy Stein for his invaluable support and comments. We also would like to thank Philippe Aghion, George Baker, Stefano DellaVigna, Edward Glaeser, Rick Green (the editor), Brian Hall, Oliver Hart, Caroline Hoxby, Dirk Jenter, Larry Katz, Tom Knox, David Laibson, Andrei Shleifer, one anonymous referee and various participants in seminars at Harvard University, MIT, University of Chicago, Northwestern University, University of California Berkeley, Stanford University, University of California Los Angeles, CalTech, Yale University, University of Michigan, Duke University, New York University, Columbia University, Wharton, London School of Economics, Centre de Recherche enÉconomie et Statistique (Paris), Centro de Estudios Monetarios y Financieros (Madrid), Ludwig-Maximilians-Universität (Munich), the annual meeting of the American Finance Association, the annual meeting of the Eastern Economics Association, the Russell Sage Summer Institute for Behavioral Economics, and the summer workshop of the Stanford Institute for Theoretical Economics for helpful comments. Mike Cho provided excellent research assistance. Malmendier acknowledges financial support from Harvard University (Divel...

We investigate whether individuals' experiences of macroeconomic outcomes have long-term effects on their risk attitudes, as often suggested for the generation that experienced the Great Depression. Using data from the Survey of Consumer Finances from 1964-2004, we find that individuals who have experienced low stock-market returns throughout their lives report lower willingness to take financial risk, are less likely to participate in the stock market, and, conditional on participating, invest a lower fraction of their liquid assets in stocks. Individuals who have experienced low bond returns are less likely to own bonds. All results are estimated controlling for age, year effects, and a broad set of household characteristics. Our estimates indicate that more recent return experiences have stronger effects, but experiences early in life still have significant influence, even several decades later. Our results can explain, for example, the relatively low stock-market participation of young households in the early 1980s, following the disappointing stock-market returns in the 1970s, and the relatively high participation of young investors in the late 1990s, following the boom years in the 1990s. In the aggregate, investors' lifetime stock-market return experiences predict aggregate stock-price dynamics as captured by the price-earnings ratio.

Does CEO overconfidence help to explain merger decisions? Overconfident CEOs overestimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs' personal overinvestment in their company and their press portrayal. We find that the odds of making an acquisition are 65% higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (-90 basis points) is significantly more negative than for non-overconfident CEOs (-12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.JEL classifications: D80; G14; G32; G34