Darryl Laws

 CEO Hubris / overconfidence bias. CEO hubris is generally defined as a CEO’s exaggerated self-confidence or pride. Prior research has studied the impacts of CEO hubris or overconfidence on firm decisions and outcomes including acquisition premiums (Hayward and Hambrick, 1997), investment distortion and venture failure (Hayward et al., 2006). The findings generally suggest that firms with overconfident CEOs pay higher premiums for acquisitions, rely on internal rather than external financing, miss their own forecasts of earnings, and often undertake more value-destroying mergers. Empirical evidence has shown that CEOs tend to be overconfident. This factor can be particularly true and tempting in the kind of environment that typically surrounds highly successful executives who may have already executed a string of accretive value transactions. This is managerial hubris, an unrealistic belief held by the bidding company’s managers that they can manage the assets of a target company more efficiently than its current management team (Hayward and Hambrick, 1997). This goes hand-in-hand with excessively optimistic expectations. This kind of bias in a serial strategy may be path dependent, since the acquiring company’s past successes (recent media attention on the CEO) can increase the risk of overconfidence. In particular ‘groupthink’ and team decisions tend to accentuate the risk of unwarranted confidence in the acquisition decision. Team ‘groupthink’ can support the underestimation of the risks involved and so lead to the illusion of control.

The biggest challenge for the analysis of overconfidence is to construct a plausible

measure of overconfidence. Biased beliefs naturally defy direct and precise measurement. In Malmendier and Tate’s (2004) previous work, they proposed two approaches to measurement;  the first is a ‘revealed beliefs’ argument. They infer CEOs’ beliefs about the future performance of their company from their personal portfolio transactions. The second approach captures how outsiders perceive the CEO. They classify CEOs as overconfident based on their portrayal in the press.

In their first approach, ‘revealed beliefs’, requires detailed information about CEOs’

personal portfolio transactions in their companies’ stock and options. Malmendier and Tate (2005) refer to a unique panel of data set on Forbes 500 companies, collected by Yermack (1995) and Hall and Liebman (1998), provides these details including duration, exercise price, and vesting period of each executive option package. To construct a measure of overconfidence, they exploited the high degree of under-diversification faced by CEOs in large U.S. public corporations. It should be made known that the CEOs of publicly traded companies compensation packages are often inclusive of extensive stock-based compensation, often in the form of Rule no. 144 restricted stock and non-tradable options. Moreover, their human capital is invested in their company. Thus, even modest risk aversion predicts that CEOs should diversify their portfolios, i.e. exercise in-the-money options or sell company stock on a pre-committed schedule.

Darryl Laws