Overconfidence, CEO Selection, and Corporate Governance

We develop a model that shows that an overconfident manager, who sometimes makes value-destroying investments, has a higher likelihood than a rational manager of being deliberately promoted to CEO under "value-maximizing" corporate governance. Moreover, a risk-averse CEO's overconfidence enhances firm value up to a point, but the effect is "nonmonotonic" and differs from that of lower risk aversion. Overconfident CEOs also underinvest in information production. The board fires both excessively diffident and excessively overconfident CEOs. Finally, Sarbanes-Oxley is predicted to improve the precision of information provided to investors, but to reduce project investment. Copyright (c) 2008 The American Finance Association.

[1]  F. Albert Wang,et al.  Overconfidence, Investor Sentiment, and Evolution , 2000 .

[2]  I. Jewitt.  Choosing between risky prospects: the characterization of comparative statics results, and location independent risk , 1989 .

[3]  Ulrike Malmendier,et al.  Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction , 2003 .

[4]  Sanford J. Grossman,et al.  AN ANALYSIS OF THE PRINCIPAL-AGENT PROBLEM , 1983 .

[5]  Daniel Ferreira,et al.  A Theory of Friendly Boards , 2007 .

[6]  David de Meza,et al.  Is the Market Biased Against Risky R&D? , 1986 .

[7]  Måns Söderbom,et al.  Managerial Risk Attitudes and Firm Performance in Ghanaian Manufacturing: an Empirical Analysis Based on Experimental Data , 2000 .

[8]  Dirk Sliwka,et al.  Performance Pay and Risk Aversion , 2006, SSRN Electronic Journal.

[9]  Managerial Incentive Problems: A Dynamic Perspective , 1999 .

[10]  I. Welch,et al.  On the Evolution of Overconfidence and Entrepreneurs , 2001 .

[11]  Artur Raviv,et al.  A Theory of Board Control and Size , 2008 .

[12]  Todd T. Milbourn,et al.  Managerial Career Concerns and Investments in Information , 2001 .

[13]  Paul R. Milgrom,et al.  Good News and Bad News: Representation Theorems and Applications , 1981 .

[14]  Andres Almazan,et al.  Entrenchment and Severance Pay in Optimal Governance Structures , 2003 .

[15]  Brad M. Barber,et al.  Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment , 1998 .

[16]  Lukas Menkhoff,et al.  Behavioural biases of institutional investors under pressure from customers: Japan and Germany vs the US , 2005 .

[17]  Anne Marie Knott,et al.  Entrepreneurial Risk and Market Entry , 2006, Manag. Sci..

[18]  Benjamin E. Hermalin,et al.  Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature , 2000 .

[19]  Jay W. Lorsch,et al.  Pawns or Potentates: The Reality of America's Corporate Boards , 1989 .

[20]  A. Thakor,et al.  Information Control, Career Concerns and Corporate Governance , 2006 .

[21]  E. Steen.  Rational Overoptimism (and Other Biases) , 2004 .

[22]  Anjan V. Thakor,et al.  Cooperation versus Competition in Agency , 1991 .

[23]  Peter C. Schotman,et al.  Measuring Risk Attitudes in a Natural Experiment: Data from the Television Game Show Lingo. , 2001 .

[24]  Laurie Larwood,et al.  Managerial myopia: Self-serving biases in organizational planning. , 1977 .

[25]  T. Jappelli,et al.  Information Acquisition and Portfolio Performance , 2006 .

[26]  Sydney Finkelstein,et al.  Why smart executives fail , 2005 .

[27]  Benjamin E. Hermalin,et al.  Toward an Economic Theory of Leadership: Leading by Example , 1997 .

[28]  A. Tversky,et al.  Judgment under Uncertainty: Heuristics and Biases , 1974, Science.

[29]  N. Weinstein.  Unrealistic optimism about future life events , 1980 .

[30]  William P. Rogerson,et al.  THE FIRST-ORDER APPROACH TO PRINCIPAL-AGENT PROBLEMS , 1985 .

[31]  R. Thaler,et al.  Financial Decision-Making in Markets and Firms: A Behavioral Perspective , 1994 .

[32]  Benjamin E. Hermalin,et al.  Endogenously Chosen Boards of Directors and Their Monitoring of the CEO , 1998 .

[33]  Mark Grinblatt,et al.  Sensation Seeking, Overconfidence, and Trading Activity , 2006 .

[34]  A. Thakor,et al.  Financial Intermediation as a Beliefs-Bridge between Optimists and Pessimists , 2004 .

[35]  Anjan V. Thakor,et al.  Information Reliability and a Theory of Financial Intermediation , 1984 .

[36]  E. Maskin,et al.  The Simple Economics of Research Portfolios , 1987 .

[37]  D. Hirshleifer.  Investor Psychology and Asset Pricing , 2001 .

[38]  J. Stiglitz,et al.  Increases in risk and in risk aversion , 1974 .

[39]  David de Meza,et al.  The Borrower's Curse: Optimism, Finance and Entrepreneurship , 1996 .

[40]  Albert S. Kyle,et al.  Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test? , 1997 .

[41]  Dara M. Khambata,et al.  Cultural Dimensions, Risk Aversion and Corporate Dividend Policy , 2005 .

[42]  Kent D. Daniel,et al.  Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions' , 1998 .

[43]  A. Shleifer,et al.  A Survey of Corporate Governance , 1996 .

[44]  E. Lazear,et al.  Rank-Order Tournaments as Optimum Labor Contracts , 1979, Journal of Political Economy.

[45]  Stephen E. Wilcox.  Investor Psychology and Security Market Under- and Overreactions , 1999 .

[46]  E. Steen,et al.  Organizational Beliefs and Managerial Vision , 2005 .

[47]  Ulrike Malmendier,et al.  CEO Overconfidence and Corporate Investment , 2002 .

[48]  Janice C. Eberly,et al.  Overconfidence, Investment Policy, and Executive Stock Options , 2003 .

[49]  Alvaro Sandroni,et al.  Overconfidence, Insurance, and Paternalism , 2007 .

[50]  Y. Amihud,et al.  Risk Reduction as a Managerial Motive for Conglomerate Mergers , 1981 .

[51]  Benjamin E. Hermalin,et al.  Trends in Corporate Governance , 2003 .

[52]  Bengt Holmstrom,et al.  Managerial Incentives and Capital Management , 1986 .

[53]  Itzhak Ben-David,et al.  Managerial Overconfidence and Corporate Policies , 2007 .

[54]  Dilip Mookherjee,et al.  Portfolio Choice in Research and Development , 1986 .

[55]  Canice Prendergast.  The Provision of Incentives in Firms , 1999 .

[56]  P. Dasgupta,et al.  Equilibrium in Competitive Insurance Markets : An Essay on the Economics of Imperfect Information , 2007 .