Corporate Governance

Executive Hubris Distorts Investment Decisions

Behavioral economists show that overconfident leaders tend to use way more of their company's internal cash flow to fund new projects.

December 01, 2005

| by Marguerite Rigoglioso

Overconfident CEOs who overestimate their ability to generate value within their company systematically make distorted decisions about when, how, and how much to invest in new projects according to research.

Ulrike Malmendier, assistant professor of finance at Stanford GSB, and Geoffrey Tate of the Wharton School, have studied how hubris affects CEOs’ corporate investment decisions as a way to apply research on individual behavior to corporate settings. In the past decade, economists have begun to acknowledge that not all decisions are reached with consistent, rational and systematic thought processes. Malmendier and Tate’s work in behavioral economics studies the illogical and idiosyncratic decisions made by some business leaders as a way to learn about how markets really function.

To measure CEO overconfidence, Malmendier and Tate studied the tendency of a CEO to overly invest in his or her 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. The researchers classified those who held on to their stock options at least one year beyond the vesting period even though the options were highly in the money. Alternatively, they classified as overconfident CEOs who did not exercise their options until the last year of their duration.

“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 leader 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 one 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 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 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.

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