The Overconfident CEO.

December 7th, 2010

Do You Want One?

by John Dicocco

Overconfidence, by definition, is a sign of self-delusion. While these delusions can spur an inventor to action in the face of long odds, CEOs at large public companies are typically prudent hard-headed realists.  Or are they?

A new study by Assistant Professor of Strategy & Innovation Timothy Simcoe (with Alberto Galasso, University of Toronto) shows that firms with “overconfident” CEOs were more innovative than their peers. While this did not always translate into a higher share price, their findings suggest that where innovation provides the best route to profitability, boards should seek “unreasonably” optimistic leaders.

Using previous research to identify overconfident executives (OCEs), Simcoe and Galasso examined how CEOs managed their personal wealth. Specifically, they labeled a CEO “overconfident” if they held onto fully vested stock option grants after a firm’s share price had climbed by at least 67 percent. About half of the CEOs in their study exhibited this behavior of exercising their options to lock in gains and diversify risk, and were thus labeled OCEs. Holding the options is akin to making a large leveraged bet on the firm, and because most OCEs continue to hold large amounts of restricted stock in their own firm, the result is a highly concentrated personal portfolio.

Could the decision to hold on to their fully vested options reflect inside information about the firm, as opposed to excessive optimism? “Perhaps,” says Simcoe, “but previous research shows that, on average, these CEOs could make the same returns by cashing out their options and investing the proceeds in an S&P 500 index. Moreover, option-holders do more deals, are less likely to use debt financing, and are thus more sensitive to cash flows than their peers. All of this is more consistent with the idea of overconfidence.” (See Identifying the Overconfident Executive.) In fact, Simcoe and Galasso hypothesized a link between overconfidence and innovation as a way to explain why firms run by an OCE don’t underperform their peers, because ordinary CEOs do fewer risky deals and are more conservative with cash flows. To test this idea, they examined data from a sample of 290 firms (primarily from manufacturing and technology-intensive industries) and 627 CEOs during the period from 1980 to 1994. (The researchers focused on this time period because they could find detailed data on CEOs’ personal portfolio management, though they replicate their findings on more recent data, using a less precise measure of overconfidence).

Simcoe and Galasso found that firms run by overconfident CEOs invest about 15% more in research and development.

When Simcoe and Galasso looked at the relationship between CEO overconfidence and innovation, the results were striking. Firms run by OCEs invested about 15% more in research and development. Their firms also generated 20% more patents per dollar of R&D spending. And the patents granted under an OCE received 20% more citations than a typical patent in the same industry and technological field. (Research on innovation often uses citations as a rough measure of the value of a patent.*)

Could the CEO really be responsible for an increase in patents? “Yes,” says Simcoe, “because patenting at these large firms reflects a broader innovation strategy that gets set at the top.” Simcoe and Galasso provide a theoretical model of innovation in their paper, and suggest that their findings are driven by an OCE’s willingness to push the firm in new directions. “We think the same ’bias for action’ we observe in their attitude toward mergers and acquisitions extends to how the firm chooses projects and manages its research and development activity.”

One piece of evidence that supports the idea that CEOs can drive innovation is that the impact of hiring an OCE is much larger in more competitive industries such as textiles, apparel, and non-specialty retail, as measured by average profit margins. Simcoe and Galasso also suggest that in these industries successful innovation provides a larger boost to the CEO’s personal reputation as a turnaround artist.

So, should boards seek to hire an overconfident CEO? “Our feeling is that overconfidence has both costs and benefits,” Simcoe says, “so it is not clear that it is always good to hire or fire an overconfident CEO. Rather, an overconfident type might be the right person in some situations and the wrong one in others.”

Nevertheless, Simcoe is enthusiastic about the implications of their research, particularly the idea that it helps to explain why markets don’t necessarily weed out “irrational” CEOs. As with great inventors, the self-delusions of an overconfident executive can have both have plusses and minuses, which make it hard for the rest of us to clearly discern the line between genius and the baseless certainty of one’s strategic view.

In psychological research literature, overconfidence is defined as a type of bias in judgment. A person is overconfident if he has unrealistically high expectations about his own ability or performance. Thus, a person may be called confident if he has unbiased beliefs.

*Patent = Innovation.
According to patentcitations.com, patents cited by many later patents tend to contain important ideas upon which many later inventors are building. “A company with a large number of cited patents is thus likely to possess technology that is central to developments in its industry…The citation links among patents also indicate the speed at which a company is innovating. Companies whose patents cite relatively recent patents are likely to be innovating faster than companies whose patents cite older patents.”

-Gregory McKenzie, filament.com.au

Psychologists have found that most people are overconfident in a variety of small ways. For example, people tend to report that they are “above average” drivers and reasonably attractive to the opposite sex. Furthermore, psychologists suggest that individuals typically attribute success to their own actions and failures to external factors, leading to a strong correlation between success and excessive self-confidence.

But how can one identify an overconfident CEO without looking inside their mind? Professors Ulrike Malmendier of UC Berkeley and Geoffrey Tate of UCLA pioneered the idea of using CEOs’ personal financial decisions to measure overconfidence (2005, 2008). They show that most CEOs have very strong incentives to diversify their personal wealth, which is often highly concentrated in a single firm, especially after a period of strong corporate performance. Logically, CEOs who choose to maintain a highly concentrated position must have an unusually high tolerance for risk, or hold very optimistic beliefs about the future performance of their firms.

To test their idea, Malmendier and Tate assembled a large data set on CEO option-holding behavior and the performance of their firms. They found that CEOs who held vested option grants that were highly “in-the-money” did not benefit from doing so. However, these CEOs were more likely to enter into M&As, and their investment behavior was more sensitive to the firm’s cash flows (consistent with a belief that markets were under-pricing their debt). Says Simcoe, “Our research takes Malmendier and Tate’s findings as the starting point and looks for a potential upside of having an overconfident CEO.”