| Overconfident managers overestimate their skill in selecting, implementing, and over-seeing projects. As a result, they overestimate the profitability of those projects to the shareholders. Further, this overvaluation causes a financing friction: overconfident CEOs believe their firm is undervalued by the capital market and, thus, are reluctant to raise external capital. So, even a manager who intends to act in the interests of the shareholders can make decisions that destroy shareholder value. We demonstrate the potential distortions of investment and takeover decisions that can arise due to managerial overconfidence.; We then test the overconfidence hypothesis in two ways. First, we use data on the personal portfolio decisions of a sample of CEOs in Forbes 500 companies. We classify CEOs as overconfident if they repeatedly fail to exercise options that are highly in the money, or if they habitually acquire stock of their own company. Second, we examine the manner in which the business press portrays these CEOs. We classify CEOs as overconfident if they are more often described as “confident” and “optimistic” than as “not confident,” “not optimistic,” “reliable,” “cautious,” “conservative,” “practical,” “frugal,” or “steady.” The two sets of measures are positively correlated. And, they all confirm the predictions of the overconfidence model. Overconfident CEOs are more likely to conduct mergers on average and this effect is due largely to diversifying (or negative expected value) mergers. Further, overconfidence has the largest effect in firms with the most cash and untapped debt capacity (or with minimal perceived financing costs). We also find that the market reacts negatively to takeover bids and that this effect is significantly stronger for overconfident managers. In the investment context, overconfident CEOs display significantly higher sensitivity of corporate investment to cash flow. And, here due to the maximization of perceived financing costs, this effect comes largely from CEOs in equity-dependent firms. |
