CEO Overconfidence and Innovation

Abstract

Are CEOs' attitudes and beliefs linked to their fims' innovative performance? This paper uses Malmendier and Tate's measure of overconfidence, based on CEO stock-option exercise, to study the relationship between a CEO's "revealed beliefs" about future performance and standard measures of corporate innovation. We begin by developing a career concern model where CEOs innovate to provide evidence of their ability. The model predicts that overconfident CEOs, who underestimate the probability of failure, are more likely to pursue innovation, and that this effect is larger in more competitive industries. We test these predictions on a panel of large publicly traded firms for the years 1980 to 1994. We nd a robust positive association between overconfidence and citation-weighted patent counts in both cross-sectional and fixed-effect models. This effect is larger in more competitive industries. Our results suggest that overconfident CEOs are more likely to take their firms in a new technological direction.

Local Gambling Preferences and Corporate Innovative Success

“…Galasso andSimcoe (2011) andHirshleifer et al (2012) find a positive influence of CEO overconfidence on innovation. In this section, we examine the interaction between CEO overconfidence and social gambling preferences.…”

“…This discussion is motivated by Galasso and Simcoe (2011) and Hirshleifer et al (2012), who show that CEO overconfidence is an important driver of innovation. To identify overconfidence, Malmendier and Tate (2008) exploit the overexposure of CEOs to the idiosyncratic risk of their firms through their holdings of stock options.…”

“…We are aware of at least two other papers that look at the behavioral nature of innovative success namely Galasso andSimcoe (2011) andHirshleifer et al (2012), which report a positive relation between chief executive officer (CEO) overconfidence and innovative activity. 3 There is an important distinction between CEO overconfidence and gambling preferences.…”

“…Chemmanur, Loutskina, and Tian (2014) and Tian and Wang (2014) show that innovative activity increases with the loss tolerance of investors supplying venture capital. Approaching the issue from a different angle, Galasso andSimcoe (2011) andHirshleifer et al (2012) show that overconfident CEOs (who have a 4 Overconfident CEOs overstate their own ability to make R&D projects successful, thus understating the possibility of potential future losses stemming from their R&D investments (Hirshleifer et al (2012)). Overconfident CEOs will therefore invest in research projects that nonoverconfident CEOs would not invest in.…”

“…Recent papers identify numerous factors that influence innovative activity. They include: managerial overconfidence (Galasso andSimcoe (2011), Hirshleifer, Low, andTeoh (2012)), institutional ownership (Aghion, Van Reenen, and Zingales (2013)), corporate governance (Sapra, Subramanian, and Subramanian (2014)), analysts following (He and Tian (2013)), stock liquidity (Fang, Tian, and Tice (2014)), banking deregulation (Chava, Oettl, Subramanian, and Subramanian (2013)), accounting conservatism (Chang, Hilary, Kang, and Zhang (2013)), nonexecutive employee stock options (Chang, Fu, Low, and Zhang (2014)), and so on. Nevertheless, the existing literature does not explain the apparent geographical disparity in innovative activity across the United States, as illustrated in Figure 1, which shows wide variation of research and development (R&D) expenditure per gross domestic product (GDP) at the state level.…”