Overconfidence, Compensation Contracts, and Capital Budgeting

Abstract

A risk-averse manager's overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.A VAST EXPERIMENTAL LITERATURE finds that individuals are usually overconfident in that they believe their knowledge to be more precise than it actually is. The incidence of overconfidence is likely to be even greater among CEOs than among individuals at large; for example, Goel and Thakor (2008) show that overconfident individuals are more likely to win the intrafirm tournaments that lead to the rank of CEO. Since overconfidence directly influences decision-making, it is logical to investigate the effects that overconfident managers have on corporate policies and firm value. How does overconfidence affect the investment decisions that managers make on behalf of shareholders? How do compensation contracts optimally adjust to these effects? Do firms benefit from managerial overconfidence? Can overconfidence ever benefit the biased

Motives for corporate cash holdings: the CEO optimism effect

“…Our data period for calculating the absolute cash change is between 1992 and 2010 and so the final sample period for this absolute-cash-change model is from 1993 to 2010. precautionary savings is relatively weak for optimistic managers. This finding is in line with the theory that optimistic managers underestimate the inherent uncertainty and riskiness of earnings (e.g., Heaton 2002;Goel and Thakor 2008;Hackbarth 2008;Gervais et al 2011). …”

“…As a final robustness check, we follow Campbell et al (2011) and use firm investment data to measure optimism. This is because the results of Malmendier and Tate (2005), Campbell et al (2011) and Gervais, Heaton, and Odean (2011) show that managerial optimism appears to have influence on firm investment.…”

Influência do Excesso de Confiança e Otimismo no Endividamento de Organizações Cinquentenárias e não Cinquentenárias Brasileiras

“…O excesso de confiança em suas habilidades torna os gestores mais otimistas quanto aos resultados dos projetos em que se envolvem (Gilson, 1989), minimizando os riscos de falência inclusive em empreendimentos com VPL negativo (Heaton, 2002). Em função destes vieses, os gestores tornam-se menos conservadores e se arriscam mais, investindo inclusive o próprio capital em ações da empresa (Malmendier & Tate, 2005;Gervais, Heaton & Odean, 2011). Decisões financeiras baseadas no excesso de confiança e otimismo conduzem a níveis mais elevados de endividamento da empresa (Barros & Silveira, 2009;Schrand & Zechman, 2010).…”

“…Barros e Silveira (2009) apontam que a alavancagem acentuada é uma característica em empresas administradas por gestores excessivamente confiantes e otimistas. Já Malmendier & Tate (2005) e Gervais et al, (2011) associam o otimismo e a confiança excessiva a uma maior propensão ao risco e a adoção de projetos mais arrojados.…”

CEO Tenure and Risk-Taking

“…On one hand, some studies suggest that inexperienced individuals tend to be more overconfident and therefore negative experiences may lower the level of overconfidence (Locke & Mann, 2003). If overconfidence is associated with more risk-taking (Gervais et al, 2011), the accumulation of experiences should lead to less risk-taking. On the other hand, an experienced manager may possess sufficient skills to take strategic risks (Simsek, 2007).…”