Darryl Laws

 Overconfidence bias. Overconfident decisions often indicate a loss of contact with reality and an overestimation of one’s own competence or capabilities, especially when the person exhibiting it is in a position of power. One of the most interesting facts that I have observed in thirty-five years of professional experience in mergers and acquisitions is that those individuals whose intellectual and interpersonal capability are the  weakest are most likely to overestimate their ability and performance. They are very likely to have confirmation biases in their decisions where they seek out information that reaffirms their choice. Example; behavioral corporate finance studies show that start-up entrepreneurs usually have overly optimistic views of their venture’s potential for success and an idealistic perspective of its enterprise value.

Doukas and Petmezas (2007) argue that managerial overconfidence results from a self-attribution bias. Specifically, overconfident CEOs feel that they have superior decision-making abilities and are more capable than their peers. The presence of these cognitive biases encourages CEOs to emphasize their own judgment in decision making and to engage in highly complex transactions such as diversifying acquisitions that are not necessarily homogenous with exiting assets of their company. Because of their overconfidence, these CEOs tend to underestimate the risks associated with a merger or overestimate the possible synergy gains from a business combination. Malmendier and Tate (2004) examine in their article, Does Overconfidence Affect Corporate Investment? CEO Overconfidence Measures Revisied, the extent to which overconfidence can help to explain merger decisions and various characteristics of the deal itself.

The analysis of overconfidence relates several branches of behavioral economics and psychology literature. First, an extensive experimental literature documents the tendency of individuals to consider themselves ‘above average’ on positive characteristics (e.g. Kruger, 1999; Alicke et al ., 1995; Alicke, 1985; Svenson, 1981). By way of an example, Svenson demonstrates that the vast majority of subjects rate their driving skills as ‘above average’. Svenson’s finding has been replicated numerous times in various countries and with respect to various IQ- or skill related outcomes other than driving. When asking a sample of entrepreneurs about their chances of success, Cooper (1988) found that 81% answered between 0 and 30% (with 33% attaching exactly zero probability to failure). However, when asked the odds of any business like theirs failing, only 39% of them answered between 0 and 30%. Larwood and Whittaker (1977) find that corporate executives are particularly prone to this form of self-serving bias.

Darryl Laws