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CEO Hubris Distorts Investment Decisions
February, 2003 IN THE PAST DECADE, economists have begun to flirt with the possibility that we do not live in a perfect world in which people make decisions consistently, rationally, and systematically. Slowly but surely, they are beginning to acknowledge that most of us do all sorts of illogical and idiosyncratic things—and that by studying such irrational behavior we can actually learn a tremendous amount about how markets really function. With the awarding of the Nobel Prize in economics last October to psychologist Daniel Kahneman and economist Vernon Smith, psychology and economics fields have at last firmly tied the knot. Their love child—behavioral economics—is now a hot research topic. One of the groundbreaking scholars in this arena is the School’s assistant professor of finance Ulrike Malmendier. Her recent study on how hubris affects CEOs’ corporate investment decisions is one of the first to apply research on individual behavior to corporate settings. Malmendier has found that CEOs who are overconfident—that is, those who overestimate their ability to generate value within the company—systematically make distorted decisions about when, how, and how much to invest in new projects. One of the major contributions of the study, which she coauthored with Harvard doctoral student Geoffrey Tate, is that it translates fuzzy behavioral concepts into measurable, empirically testable phenomena. Malmendier was able to devise a clever measure for overconfidence: the tendency of a CEO to overly invest in his own company by habitually buying its stock or by holding on to stock options long beyond the point when they should be exercised. “These CEOs tend to think that under their glorious leadership the stock prices will keep going up, so they keep holding on to their shares and their options,” Malmendier explains. Looking at data on CEOs of 477 Fortune 500 companies for the years 1980 to 1994, she determined those CEOs who held on to their stock options beyond the fifth year and who were at least 67 percent in the money were overconfident. She also classified as overconfident CEOs who did not exercise their options until expiration. “What the CEO does with his own money is really the telling indicator about overconfidence,” Malmendier says. “It’s a much more accurate measure than whether, say, he boasts in the media or to investors about how strong his company is. That could all be show.” The study related the overconfidence bias to distortions in corporate investment decisions that seem to be a regular part of the business landscape—particularly the fact that managers sometimes restrict external financing to fund new projects and rely instead on their company’s own internal cash flow. Some studies have tried to justify managers’ reluctance to go to the capital market by stating that the markets never have quite enough information about a given company to value its stock properly. Malmendier’s study is the first to identify CEO behavior as the factor behind this phenomenon. “Overconfident CEOs think their investment projects are greater than they actually are. They don’t want to go to the outside equity market and issue more shares for their projects because they think the market will unfairly undervalue the stock. Often, however, the market is in fact accurately perceiving the reality of the situation, it’s just that the CEO is overly optimistic,” says Malmendier. “These CEOs therefore tend to rely on their own available funds for growth and expansion projects. They end up making investment decisions not on the quality of their projects—which is what a wise CEO would do—but rather on how much cash flow they have available.” A typical CEO will invest 19 percent of available marginal cash flow in investment projects, the study found, but an overconfident CEO will invest 36 percent. “Those with a lot of available cash therefore end up investing in many projects that they shouldn’t,” says Malmendier. As the recent WorldCom scandal demonstrated, inflated investment decisions can harm a company. But Malmendier cautions that overconfidence is not necessarily a bad trait. “We can’t really say anything conclusive about the net effect of overconfidence in this study, because sometimes it is good in business,” she says. “The overconfident CEO can also inspire and push his employees to do great things.” The study has implications for corporate governance, however. “CEOs who are overly convinced about their own leadership capabilities are not actively trying to get rich at shareholders’ expense; they’re just misperceiving the situation,” she explains. “So giving them more stocks and options as an incentive to increase shareholder value is not going to help; it’s just going to perpetuate their distorted behavior.” Malmendier suggests instead that company boards become involved in the affairs of the organization more actively and more frequently. “The CEO should have to consult with the board before he goes ahead with large investment projects, even if they are financed internally. That’s what should be going on,” she concludes. —MARGUERITE RIGOGLIOSO |
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CEO
Hubris Distorts Investment Decisions
