ABF 3 - CEO Overconfidence

Introduction
CEO overconfidence and corporate policies

Other applications of overconfidence research
Session 3: Bright Sides and Dark Sides of Overconfidence
Aleksandar Andonov
FEM11076 Advanced Behavioral Finance

18 March 2015
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Introduction
CEO overconfidence and corporate policies Overconfidence
Lecture 3: Overconfidence
1 Definition of overconfidence.
2 Dark sides of CEO overconfidence:

Ben-David, Graham and Harvey (2013).
Malmendier and Tate (2005).
3 Bright sides of CEO overconfidence:

Hirshleifer, Low and Teoh (2012).
4 Other applications of overconfidence research.
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Introduction
What is overconfidence?
Overconfidence is a behavioral bias that causes people to overestimate their

knowledge, underestimate risks, and exaggerate their ability to control events.
Three manifestations of overconfidence:

1 Miscalibration (overprecision).
2 Better than the average effect.
3 Illusion of control.
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Introduction
Overconfidence - illusion of control
Illusion of control refers to the tendency of individuals to overestimate their

ability to control events over which they have limited influence.
Langer and Roth (1975): “Heads I Win, Tails It’s Chance”, Journal of Personality
and Social Psychology, 32(6), 951-955.
Subjects predicted coin tossing outcomes. Those with early successes, considered
themselves skilled in predicting coin tossing.
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Introduction
Overconfidence - better than the average effect
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.
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Introduction
Overconfidence - miscalibration
Miscalibration is the systematic underestimation of the range of potential

outcomes, i.e. excessive confidence about having accurate information.
Reasons for miscalibration:

Agents overestimate their ability to predict the future.
Agents underestimate the volatility of random effects.
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Introduction
Miscalibration vs. Optimism

Optimistic managers overestimate the mean of their firm cash flows.
Miscalibrated managers underestimate the volatility of their firm future cash flows.
E.g. What is your expectation about the EPS next year of your firm?
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Introduction Ben-David, Graham and Harvey (2013)
CEO overconfidence and corporate policies Malmendier and Tate (2005)
Other applications of overconfidence research Hirshleifer, Low and Teoh (2012)


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Corporate investments
Financing corporate investments:

1 Internal financing (cash flow).
2 External financing sources:
- Borrow debt (bank or bonds).
- Issue equity.
Corporate investment distortions:

1 Underinvestment - good projects can be rejected.
2 Overinvestment - bad projects can be accepted.
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Explanations for investment distortions:
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.
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Research questions
1 Are CFOs miscalibrated? Measure the narrowness of their distribution of

predicted future returns.
2 Does overprecision spread to corporate planning and forecasting?
3 What is the effect of miscalibration on corporate investments and leverage?
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Eliciting the distribution of returns
13,300 quarterly predictions of S&P 500 returns by CFOs.
10-year panel during the 2001-2011 period.
Over the next year, I expect the annual S&P 500 return will be:
There is a 1-in-10 chance the actual return will be less than %.
I expect the return to be: %.
There is a 1-in-10 chance the actual return will be greater than %.
The second question relates to annualized forecast over the next 10 years.
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Imputing CFO volatility estimates
Wide distributions - subjective uncertainty.

Narrow distributions - subjective confidence.
x(0.90)−x(0.10)
σ̂i = z
where z is the number of standard deviations within the confidence interval.

Z equal 2.65 for 80% confidence intervals in a normal distribution.
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Are CFOs miscalibrated?

Only 36% of S&P500 realizations fall within 80% confidence interval.
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Distribution of imputed volatilities

The realized distribution is centered at 12% and most of the distribution lies
between 8% and 25%.
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Distribution of imputed volatilities

The imputed individual volatilities of CFO forecasts are centered at 4%, and most
of the distribution lies between 1% and 15%.
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Are CFOs more miscalibrated in volatile periods?
In quarters with an above-median VIX, only 23.0% of the time do one-year-ahead

S&P 500 realizations fall within the 80% confidence interval that CFOs provide.
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Understanding CFO forecasts and miscalibration
CFOs cannot predict future returns: no relation between S&P 500 future
one-year realized returns and CFO forecasts.
Mascalibration varies over time: the confidence bounds of CFO forecasts are
wider in periods of increased volatility, but the calibration does not improve.
Education and age have a positive effect on long term miscalibration, but no
relation with short term miscalibration.
CFOs forecast wider confidence intervals for long-term forecasts because they
(1) allow for larger mistakes and parameter uncertainty over longer horizons,
and (2) seem to believe that volatility will increase in the future.
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Miscalibration and corporate actions
Greater CFO miscalibration is associated with:
1 Narrower distribution on own-project return estimation.
2 More intense corporate investment.
3 Higher debt leverage.
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Miscalibration regarding own-firm projects

A one standard deviation shift in short-term market miscalibration is associated
with a shift of 41.8% of one standard deviation of own-firm IRR miscalibration.
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Miscalibration and corporate policies

Long-term overprecision is associated with more corporate investments.
Short-term miscalibration is associated with moderate increase in leverage.
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Is there a causal effect of miscalibration?
Do miscalibrated CFOs make bold decisions, or do firms with bold strategies

make CFOs miscalibrated?
Test: examine the effect of miscalibrated CFO who take office in a firm.
Result: investment intensity seems to increase in a firm when hiring a new CFO.
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Summary
1 CFOs are severely miscalibrated.
2 CFO overprecision is related to corporate decision making.
3 Implications for investors, regulators, and other stakeholders.
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Motivation
Overconfidence based mainly on the better-than-average effect and optimism.
Overconfident CEOs systematically overestimate the return to their investment

projects and the value of their company.
Implications for corporate investments:
CEOs overinvest, if they have sufficient internal funds and are not disciplined
by the capital market or corporate governance mechanisms. They
overestimate the returns on their projects.
CEOs may underinvest, if they do not have sufficient internal funds. They
are reluctant to issue new equity because they perceive the stock of their
company to be undervalued by the market.
By doing so, CEOs may believe that they act in the best interests of shareholders.
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Hypotheses and empirical predictions
1 The investments of overconfident CEOs are more sensitive to cash flows

than the investment of CEOs who are not overconfident.
2 The investment–cash flow sensitivity of overconfident CEOs is more

pronounced in equity-dependent firms.
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Overconfidence measures
Measures based on CEOs overexposure to the idiosyncratic risk of their firms

(human capital, stocks and options bear the risk of same company).
Risk-aversion and underdiversification predict early exercise of executive options.
Overconfident CEOs may overestimate the future returns of their projects.
They believe that the stock prices will rise under their leadership more than they
objectively should expect.
Overconfidence induces CEOs to postpone option exercise or even buy additional

company stock.
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Overconfidence measures
1 Holder 67:
CEOs are overconfident if at least twice during the sample period they did not
exercise any options when the options were more than 67% in the money.
- 58 out of 113 CEOs.
2 Longholder:
CEOs are classified as overconfident if they ever hold an option until the last
year of its duration.
3 Net buyer:
CEOs are identified as overconfident if they were net buyers of company equity
during their first five years in the sample.
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Understanding option based overconfidence measures

Hall and Murphy (2002): optimal early exercise decisions for undiversified CEOs.
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Alternative interpretations of the measures

1 Inside (private) information:
- Positive information is transitory, overconfidence is persistent.
- Inside information hypothesis predicts switches between holding and execution.
- CEOs also do not gain positive abnormal returns form holding option or stocks.
2 Signaling:
- Does not predict investment-cash flow.
- Net buyer measure for two disjoint periods of time.
3 Risk tolerance (lower risk aversion):
- Less risk averse CEOs should borrow more and be less sensitive to cash flows.
4 Tax reasons.
5 Procrastination:
- CEOs trade on their personal portfolios.
- CEOs engage in M&A activity.
- Inertia does not predict purchasing additional stocks (net buyer).
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Overconfidence and corporate investments

Dependent variable: firm capital expenditures normalized by capital.
CEOs who demonstrate a higher level of overconfidence in their personal portfolio
decisions also exhibit a higher sensitivity of corporate investment to cash flow.
Similar results for Longholder and Net buyer measures.
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Overconfidence and financial constrains

Sample split into quintiles based on Kaplan-Zingales index of financial constraint.
The effect of overconfidence on the sensitivity of investment to cash flow is
significant only for the most equity-dependent firms.
Also documented among the youngest firms, the smallest firms, firms that pay
the fewest dividends, and the sample of firms with low credit ratings.
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Summary
Overconfidence measured as overexposure of CEOs to the idiosyncratic risk of

their firms.
There is a positive relation between CEO overconfidence and investment-cash

flow sensitivity.
The investment–cash flow sensitivity of overconfident CEOs is more

pronounced in equity-dependent firms.
CEOs with financial education have less investment-cash flow sensitivity.
Need for better governance and more involvement of independent directors

(shareholders).
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Malmendier and Tate (2008)

CEO overconfidence and merger activity - number of mergers per CEO:
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Malmendier and Tate (2008)
Overconfident CEO make value-destroying mergers:
1 Overconfident are 65% more likely to make an acquisition.
2 They are more likely to make (bad) diversifying mergers.
3 The effects are strongest if CEOs have access to internal financing.
4 The market reaction is significantly more negative for mergers conducted by

overconfident CEOs.
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Conclusion: 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:
Conduct value-destroying mergers.
Implement projects with excessive risk.
Implement projects with negative NPV.
Shun profitable projects with positive NPV.
All these problems, while CEOs believe that they act in the best interest of their
shareholders...
Why companies hire overconfident CEOs?
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Overconfidence puzzle
Puzzle: Why firms employ overconfident managers and give them leeway to follow
their beliefs in making major investment and financing decisions?
Hypothesis: Firms with overconfident managers accept greater risk, invest more
heavily in innovative projects, and achieve greater innovation.
Overestimate expected cash flows.
Underestimate risk.
Potential effect on performance:

Negative: overconfident managers undertake projects with low expected payoff.
Positive: overconfident managers accept good but risky projects, avoided by
rational managers.
Bottom line: Overconfident managers are better innovators and can translate
growth opportunities into firm value, but only in innovative industries.
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Measuring CEO overconfidence

1 Malmendier and Tate (2005) options exercise measure:
- A manager who chooses to be exposed to the firm’s idiosyncratic risk is likely
to be overconfident about the firm’s prospects.
- Persistent over time (once overconfident, always overconfident).
- 61.08% of observations are classified as overconfident CEOs.
2 CEO portreyal in news media:

- This measure counts the number of articles containing words related to
overconfidence in proximity to the company name and the keyword “CEO.”
t t

 X X
1 if ais > bis
ConfidentCEO(Press)i,t = s=1 s=1

0 otherwise

- Overconfidence is measured for each CEO i in year t - varies over time.

- Only 8.12% of observations classified as overconfident CEOs.
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Measuring innovation
1 Innovation related investments (input):

- Level of R&D expenditures scaled by assets.
2 Innovation success (output):

- Number of patent applications.
- Total patent citations count.
- Time truncation bias: adjustments for technology class and year.
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Summary statistics
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CEO overconfidence and stock return volatility
Overconfident managers are more willing to undertake risky projects because they
expect to succeed in such undertakings.
Press-based measure: having an overconfident CEO is associated with daily
return volatility being higher by 20 basis points, which annualizes to 3% per year.
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CEO overconfidence and R&D expenditures

Input: Overconfident managers increase innovative investment (R&D expenditures).
Output:
- Overconfident managers are associated with a 9% to 28% higher patent count.
- Overconfidence increases Qcitation count by about 17%-40% and TTcitation count
by 11%-20%.
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CEO overconfidence and R&D expenditures

Input: Overconfident managers increase innovative investment (R&D expenditures).
Output:
- Overconfident managers are associated with a 9% to 28% higher patent count.
- Overconfidence increases Qcitation count by about 17%-40% and TTcitation count
by 11%-20%.
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Effect of industry innovativeness
Overconfidence is associated with higher innovation only within innovative industries.

Productivity of R&D expenditures: only in innovative industries, overconfidence is
associated with increased citation per patent.
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Is there a causal effect of CEO overconfidence?
Potential interpretations:
1 Overconfidence causes managers to overestimate their prospects for success in
risky endeavors such as innovation.
2 Firms with opportunities for innovative projects appoint overconfident CEOs.
Causality test:
Overconfidence is persistent, while firm growth opportunities vary over time.
Matching effects between CEO overconfidence and time-varying firm
characteristics are likely to be strongest when the CEO is first appointed.
Eliminate years when manager is just appointed and reexamine relations.
Results:
Overconfidence continues to be positively related to volatility, R&D expenditures
and innovative output.
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CEO overconfidence and firm value

Overconfident managers are more willing to undertake risky but valuable innovation:
- Industry P/E ratio as an exogenous instrument for firm growth.
- Tobin’s Q measures firm value.
- Overconfident are able to transform growth opportunities into firm value.
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Summary
Puzzle: Why firms employ overconfident managers and give them leeway to follow
their beliefs in making major investment and financing decisions?
1 CEO overconfidence is associated with riskier projects, greater investment in

innovation, and greater innovation output.
2 Greater innovative output is achieved only in innovative industries.
3 In innovative industries, overconfident CEOs are more effective at exploiting
growth opportunities and translating them into firm value.
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Introduction
Trading and overconfidence
Experience effects


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Introduction
Experience effects
Excessive trading volume

Rational models predict little trading: I am reluctant to buy if you are ready to sell.
However, French (2008) shows rapidly increasing annual turnover of stocks.
It is hard to make sense of this high trading volume without overconfidence.

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Introduction
Experience effects
Excessive trading of individual investors

Barber and Odean (2000) research:
Large discount brokerage data over 1991-1996 period.
Individual who trade the most, perform the worst.
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Introduction
Experience effects
Overconfidence as explanation for excessive trading

Overconfidence explanation: people believe that they have information strong
enough to justify a trade, whereas in fact the information is too weak to warrant
any action.
Grinblatt and Keloharju (2009) research:

Trading records for investors in Finland.
Measure of each’s trader overconfidence: based on psychological and aptitude
tests at age 18, before military service.
Overconfidence measure: self-reported confidence level minus how confident
you should be based on your test performance.
Find a significant link between overconfidence and intensity of trading activity.
Barber and Odean (2002) research:

Psychological studies show that men are more overconfident than women.
Confirm the hypothesis that men will trade more.
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Introduction
Experience effects
Experience effects
When making decisions, we should take account of all past data...

But some people pay excessive attention to data they have personally experienced.
Applications:
1 Household portfolio choice.

Malmendier and Nagel (2012): household decisions about how much to
invest in the stock market can be explained by the stock returns they have
personally experienced.
2 Corporate financial policies.
Malmendier, Tate and Yan (2011): CEOs who have lived through economic
crises are more conservative in their use of debt.
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Introduction
Experience effects
Behavioral biases related to experience effects
Agents can also create a biased interpretation of their experience:
1 Self-attribution bias:
People’s tendency to ascribe any success they have in some activity to their
own talents, while blaming failure on bad luck.
2 Hindsight bias:
The tendency of people to believe, after an event has occurred, that they
predicted it before it happened.
3 Availability bias:
When judging the probability of an event people search their memories for
relevant information.
- Only successful traders appear in financial media.
- The effect of advertisements: E*TRADE baby commercials.
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Introduction
Experience effects
Barber and Odean (2002): experience and overconfidence
The effect of online trading on performance:

Investors who switch to online trading perform well prior to going online,
beating the market by more than 2%.
After going online, they trade more actively, more speculatively, and lees
profitably - underperformance by more than 3% annually.
Cause: self-attribution bias + overconfidence.
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Introduction
Experience effects
Conclusion
The effects of overconfidence:
Dark sides - corporate investment distortions and excessive trading.
Bright side - greater innovation.
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Introduction

CEO overconfidence and corporate policies

Session 3: Bright Sides and Dark Sides of Overconfidence

FEM11076 Advanced Behavioral Finance

2 Dark sides of CEO overconfidence:

3 Bright sides of CEO overconfidence:

4 Other applications of overconfidence research.

Overconfidence is a behavioral bias that causes people to overestimate their

Three manifestations of overconfidence:

Overconfidence - illusion of control

Illusion of control refers to the tendency of individuals to overestimate their

Overconfidence - better than the average effect

Malmendier and Tate (2005).

Miscalibration is the systematic underestimation of the range of potential

Reasons for miscalibration:

Ben-David, Graham and Harvey (2013).

Miscalibration vs. Optimism

2 Dark sides of CEO overconfidence:

3 Bright sides of CEO overconfidence:

4 Other applications of overconfidence research.

Financing corporate investments:

Corporate investment distortions:

Explanations for investment distortions:

1 Agency view - misalignment of managerial and shareholders objectives:

2 Asymmetric information between insiders and the capital market:

3 CEO overconfidence and corporate policies:

2 Dark sides of CEO overconfidence:

3 Bright sides of CEO overconfidence:

4 Other applications of overconfidence research.

1 Are CFOs miscalibrated? Measure the narrowness of their distribution of

Eliciting the distribution of returns

13,300 quarterly predictions of S&P 500 returns by CFOs.

10-year panel during the 2001-2011 period.

Imputing CFO volatility estimates

Wide distributions - subjective uncertainty.

where z is the number of standard deviations within the confidence interval.

Are CFOs miscalibrated?

Distribution of imputed volatilities

Distribution of imputed volatilities

Are CFOs more miscalibrated in volatile periods?

In quarters with an above-median VIX, only 23.0% of the time do one-year-ahead

Understanding CFO forecasts and miscalibration

Miscalibration and corporate actions

Greater CFO miscalibration is associated with:

1 Narrower distribution on own-project return estimation.

2 More intense corporate investment.

3 Higher debt leverage.

Miscalibration regarding own-firm projects

Miscalibration and corporate policies

Is there a causal effect of miscalibration?

Do miscalibrated CFOs make bold decisions, or do firms with bold strategies

1 CFOs are severely miscalibrated.

2 CFO overprecision is related to corporate decision making.

3 Implications for investors, regulators, and other stakeholders.

2 Dark sides of CEO overconfidence:

3 Bright sides of CEO overconfidence:

4 Other applications of overconfidence research.

Overconfidence based mainly on the better-than-average effect and optimism.

Overconfident CEOs systematically overestimate the return to their investment

Implications for corporate investments:

Hypotheses and empirical predictions

1 The investments of overconfident CEOs are more sensitive to cash flows

2 The investment–cash flow sensitivity of overconfident CEOs is more