European Financial Management, Vol. 11, No.

5, 2005, 649–659

Does Overconfidence Affect Corporate

Investment? CEO Overconfidence
Measures Revisited
Ulrike Malmendier
Graduate School of Business, Stanford University, Stanford, CA 94305, USA
email: [email protected]

Geoffrey Tate
Wharton School, University of Pennsylvania, Philadelphia PA 19104, USA
email: [email protected]

Abstract
This article presents the growing research area of Behavioural Corporate Finance in the
context of one specific example: distortions in corporate investment due to CEO over-
confidence. We first review the relevant psychology and experimental evidence on
overconfidence. We then summarise the results of Malmendier and Tate (2005a) on the
impact of overconfidence on corporate investment. We present supplementary evidence
on the relationship between CEOs’ press portrayals and overconfident investment decisions.
This alternative approach to measuring overconfidence, developed in Malmendier
and Tate (2005b), relies on the perception of outsiders rather than the CEO’s own
actions. The robustness of the results across such diverse proxies jointly corroborates
previous findings and suggests new avenues to measuring executive overconfidence.

Keywords: behavioural corporate finance; CEO overconfidence; corporate

investment.
JEL classification: G14, G31, G32, D80

1. Introduction

The literature in behavioural economics and behavioural finance departs from the
traditional economic model to incorporate psychological evidence on non-standard
preferences and beliefs, such as loss aversion, sunk-cost fallacy, or overconfidence.
While much of the evidence on such deviations is hard to dispute, it is less clear
whether economists need to account for them. The ultimate purpose within our
discipline, one may argue, is predicting economic outcomes rather than the correct
description of decision-making processes. A key test for the relevance of behavioural
approaches, then, is the explanatory power of behavioural features once we go beyond
the realm of individual decision-making. As economists we are interested in market
interactions. In the market, high-stake incentives and repeated transactions might
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02148, USA.
650 Ulrike Malmendier and Geoffrey Tate

discipline deviations (Stigler, 1958; Becker, 1957). The question is what happens in
market settings where behavioural agents interact with (potentially) unbiased agents.
Does market interaction foster learning and diminish those mistakes? Or does the
presence of unbiased agents, who may exploit the non-standard behaviour of others,
exacerbate the impact of individual biases on market outcomes?
The growing literature in Behavioural Corporate Finance provides insight into these
questions in the context of corporate finance decision-making. Non-standard preferences
and beliefs are important from two perspectives. The first perspective recognises that
investors make mistakes which managers exploit. An example is the issuance of equity by
rational managers when firms are overvalued due to investor sentiment (Baker and
Wurgler 2000, 2002). The second perspective recognises that managers make systematic
mistakes which markets do not fully correct, such as overinvestment.1
The rest of the paper focuses on a specific example of managerial biases: CEO over-
confidence and its impact on corporate investment. We first review the evidence of
investment distortions presented in Malmendier and Tate (2005a). We present supple-
mentary evidence on the relationship between CEOs’ press portrayals and overconfident
investment decisions. This alternative approach to measuring overconfidence is a simpli-
fied version of the overconfidence measure developed in Malmendier and Tate (2005b). It
relies on the perception of outsiders rather than the CEO’s own actions. We conclude with
a discussion of corporate governance implications.

2. Overconfidence: Definition and Psychology Evidence

The analysis of overconfidence relates several branches of the 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). Svenson, for example, 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 et al. (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 (and management students) are
particularly prone to this form of self-serving bias.
The ‘better than average’ effect also affects the attribution of causality. Because
individuals expect their behaviour to produce success, they attribute outcomes to their
actions when they succeed and to bad luck when they fail (Miller and Ross, 1975; Feather
and Simon, 1971). This self-serving attribution of outcomes reinforces overconfidence.

1
A third, within-firm perspective analyses how higher-level management responds to biases of
lower-level employees, for example by giving stock options to employees who are overly excited
about the firm (Bergman and Jenter, 2005). For an overview on the ‘Behavioural Economics of
Organisations’ see Camerer and Malmendier (forthcoming).
A fourth string of related literature analyses the interaction of firms with biased consumers
and analyses how firms’ contract design and product design responds to consumer biases
(‘Behavioural Industrial Organisations’, e. g. Gabaix and Laibson, 2005; DellaVigna and
Malmendier, 2004).
For a survey that covers the first two perspectives, see Baker et al. (forthcoming).

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 Does Overconfidence Affect Corporate Investment? 651

The ‘better than average’ effect is particularly likely to apply to high-rank execu-
tives for a number of reasons. First, Kruger (1999) and Camerer and Lovallo (1999)
show that the effect is especially strong among highly skilled individuals, possibly due to
insufficient weighting of the comparison group (‘base rate neglect’). If CEOs compare
themselves to the average manager rather than other CEOs, they may conclude they are
better than average at picking investment projects or merger targets. Second, the effect
tends to be strongest for outcomes that are abstractly defined rather than in a one-to-one
comparison with other people (Moore and Kim, 2003). CEOs will rarely have a direct
comparison. Decisions such as large-scale investments are naturally complex and hard to
compare across firms, making it hard to detect overestimation.
A related branch of the self-enhancement literature documents the tendency of indivi-
duals to be too optimistic about their own future prospects (Weinstein, 1980; Kunda,
1987; Weinstein and Klein, 2002). Individuals are the most optimistic about outcomes
which they believe are under their control (Langer, 1975). And individuals are more prone
to overestimate outcomes to which they are highly committed (Weinstein, 1980). Top
corporate managers are likely to satisfy both of these pre-conditions. First, a CEO has the
ultimate say about his firm’s big strategic decisions and decides whether or not a large-
scale investment or a merger goes ahead. Such a position may induce the CEO to believe
that he or she can also control the outcome – and thus to underestimate the likelihood of
failure (March and Shapira, 1987). Second, a large portion of CEO compensation (stocks
and options) depends on how well the company is doing. Similarly, the value of a CEO’s
human capital (probability of firing, outside options) is tightly related to company
returns. So, for compensation and career reasons alone, we would expect top executives
to be highly committed to the outcome of their corporate decisions.
Moreover, the higher up managers climb on the corporate ladder the more likely
they are to face exactly the type of decision-making environment under which biases
are likely to persist. Low-frequency and noisy feedback, for example, are key pre-
dictors of biased decision making (Nisbett and Ross, 1980). And top-level executive
decisions such as large-scale investments, merger agreements, or capital restructuring
are relatively rare events in the life of one company, and each project has many
distinct features which make comparison to past experiences difficult.
In summary, there is strong support for the hypothesis that top corporate decision-
makers persistently overestimate their own skills relative to others and, as a result, are
too optimistic about the outcomes of their decisions. We formalise this notion by
assuming that overconfident managers overestimate the expected returns to their corpo-
rate decisions. This assumption is similar to the notion of ‘hubris’ in Roll (1986). It also
relates to the frameworks of Heaton (2002) and Landier and Thesmar (2004), who model
managers that overestimate the probability of project success. The latter authors use the
term ‘optimism’ rather than ‘confidence’. We choose the ‘confidence’ terminology, as in
Camerer and Lovallo (1999), to draw a tighter link with the literature on excessive self-
confidence and the ‘better than average’ effect. Our terminology highlights the distinc-
tion between overoptimistic beliefs that result from overconfidence and general optimism
about exogenous events (like the outbreak of a war).2

2
There is a strong precedent in the psychology literature for using ‘confidence’ to describe biases
in self-assessment and ‘optimism’ for biases in beliefs about exogenous events (see Bazerman
(2002) and contrast Feather and Simon (1971) and Langer (1975) with, for instance, Hey (1984)
and Milburn (1978)).

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652 Ulrike Malmendier and Geoffrey Tate

Our approach is distinct from the finance literature, predominantly on stock trad-
ing, which models overconfidence as the underestimation of variance (typically of a
signal of firm value). This assumption draws on the calibration literature, which
shows that individuals tend to overestimate the accuracy of their information.3
There is some evidence that managers are prone to this bias (Moore, 1977). In
corporate finance, this form of overconfidence has been applied to contracting with
managers (Gervais et al., 2003) and succession tournaments (Goel and Thakor, 2000).

3. Overconfidence and Managerial Decisions

3.1. Measuring CEO overconfidence

The biggest challenge for the analysis of overconfidence is to construct a plausible
measure of overconfidence. Biased beliefs naturally defy direct and precise measure-
ment. In our previous work, we propose two approaches. The first is a ‘revealed
beliefs’ argument. We infer CEOs’ beliefs about the future performance of their
company from their personal portfolio transactions. The second approach captures
how outsiders perceive the CEO. We classify CEOs as overconfident based on their
portrayal in the press.
The first approach (‘revealed beliefs’) requires detailed information about CEOs’
personal portfolio transactions in their companies’ stock and options. A unique panel
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,
we exploit the high degree of under-diversification faced by CEOs in large US
corporations. These CEOs receive extensive stock-based compensation, often in the
form of 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.4
Some CEOs, however, do exactly the opposite. They hold options that are well in
the money and buy, rather than sell, company stock. These CEOs bet their personal
wealth on future company stock performance. One way to measure overconfidence,
then, is to look at CEOs who hold options beyond rational thresholds. Calibrations of
the Hall and Murphy (2002) model (with CRRA utility, risk aversion of 3, and 67%
of wealth in company stock) would suggest exercise entering the final year of duration
when the option value exceeds 40%. The median option held to expiration is in excess
of 200% in the money. Alternatively, we look at a common year beyond the vesting
period for all of the options in our sample (year 5). Here, we again use the Hall and
Murphy model to calibrate a range of rational thresholds for exercise (varying risk
aversion and diversification). Then, we consider the subsample of CEOs with options
beyond these benchmarks and compare CEOs who exercise (rational) to CEOs who
continue to hold (overconfident). The sample restriction assures that we do not
contaminate the overconfidence measure with CEOs who have not yet had the

3
Alpert and Raiffa, 1982; Fischhoff et al. 1977.
4
Precommitment allows to avoid sending negative signals to the market.

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 Does Overconfidence Affect Corporate Investment? 653

opportunity to display overconfidence. To check whether these exercise decisions are

driven by inside information, we compute the returns CEOs earned as a result of their
trading decisions. We find no evidence that CEOs earn abnormal returns by holding
options beyond rational benchmarks. Indeed, it appears that CEOs who hold all the
way to expiration would have been better off on average by exercising (1, 2, 3, or 4
years) earlier and simply investing the proceeds in the S&P 500.
A second measure, proposed in Malmendier and Tate (2005b), builds on the
perception of outsiders. We hand-collect data on how the press portrays each of the
CEOs during the sample period. We search for articles referring to the CEOs in The
New York Times, Business Week, Financial Times, The Economist and The Wall Street
Journal. For each CEO and sample year, we record the number of articles containing
the words ‘confident’ or ‘confidence;’ the number of articles containing the words
‘optimistic’ or ‘optimism;’ and the number of articles containing the words ‘reliable’,
‘cautious’, ‘conservative’, ‘practical’, ‘frugal’, or ‘steady’. We hand-check that the
terms are used to describe the CEO in question and separate out articles describing
the CEO as ‘not confident’ or ‘not optimistic’. We then construct an indicator,
TOTALdummy, equal to 1 if a CEO is more often described as ‘confident’ and
‘optimistic’ or as ‘reliable’, ‘cautious’, ‘conservative’, ‘practical’, ‘frugal’, or ‘steady’.
This alternative indicator of CEO confidence is significantly positively correlated with
our portfolio measures.

3.2. Applications

Our next step is to link the behaviour of CEOs on their private accounts to their
behaviour on the corporate accounts. Do CEOs who personally overinvest in their
company (and make losses from this underdiversification) also display overconfidence
in their corporate decisions? Similarly, how does outside perception as ‘confident’ and
‘optimistic’ relate to corporate decision-making? In our previous work, we have
considered three types of decisions: investment, merger, and capital structure deci-
sions. Here, we focus on the investment setting of Malmendier and Tate (2005a) and
augment it with new evidence based on our press-based measure of overconfidence.
To start with an example, consider the legacy of Roger Smith, the CEO of General
Motors from 1981 to 1990 – and an overconfident CEO according to our measures.
Smith believed that fully robotised plants were the future of automobile production.
Plants with no human presence would allow GM to cut costs and to reduce the
company’s unionised labour force. He invested $40 billion to automate GM’s plants.
His vision led to massive layoffs at GM. It also triggered negative responses from
business analysts and engineers alike who did not believe the technology was
advanced enough for practical application. Outside perception proved correct. The
result of Smith’s pet project was plants in which ‘the robots often began dismembering
each other, smashing cars, spraying paint everywhere or even fitting the wrong
equipment’.5 Ironically, the move to robotised plants eventually increased the need
for human labour to ‘baby-sit’ the robots and make repairs when they broke. Roughly
20 years later, many of the robots remain unused.6

5
The Economist, 10 August 1991, ‘When GM’s robots ran amok’.
6
Conrad (2001).

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654 Ulrike Malmendier and Geoffrey Tate

Our overconfidence measures, outlined above, capture precisely the discrepancy in

beliefs between the CEO and the market documented in the GM case. Differently
from traditional explanations, such as empire building, the CEO truly believes that he
is creating value with his (over-)investment.
The implications of overconfidence are, however, more subtle than mere over-
investment. An overconfident CEO persistently feels undervalued by the capital
market and is thus reluctant to issue risky securities to finance his projects (Heaton,
2002). This effect is a re-interpretation of traditional Myers-Majluf (1984) type models
with asymmetric information. There, the manager has inside information, and good
types are reluctant to issue equity since they will be taken for bad types. Here, the
overconfident manager thinks he has (positive) inside information, with the same
effect on equity issuance. Overconfidence amounts to ‘perceived asymmetric informa-
tion’. The perceived undervaluation induces CEOs to abstain from projects (and even
underinvest) when they cannot be financed without tapping the resources of
(unbiased) outsiders. In this case, an influx of cash would enable (overconfident)
CEOs to undertake these foregone projects. Thus, we do not have a prediction on
the level of investment, but overconfidence predicts that investment should be sensi-
tive to cash flow. Moreover, such investment-cash flow sensitivity should be strongest
in firms with few internal resources.
As reported in Malmendier and Tate (2004a), the data confirm these predictions:
CEOs we classify as overconfident are more sensitive to cash flow in their investment
decisions and particularly if internal resources are scarce. Overconfidence thus helps to
explain the ‘investment-cash flow sensitivity puzzle’ in the corporate finance literature.
The investment context is also well-suited to apply our second, press-based measure
of overconfidence. In other contexts such as mergers, the press measure is applicable
only after accounting for an important endogeneity problem: having completed a
merger in the past may change the tenor of future press coverage.7 The same concern
is much less severe in the context of investment projects, which are numerous and
typically receive much less or no press attention. Replicating the results of
Malmendier and Tate (2005a) with the press-based measure would jointly corroborate
the importance of overconfidence for corporate investment and confirm the validity of
the overconfidence measures. We thus apply the press measure to corporate invest-
ment, using the standard regression specification:
Iit ¼b1 þb2 Qit1 þb3 Cit þXit0 B4 þb5 Dit þb6 Cit Qit1 þCit Xit 0 B7 þb8 Cit Dit þeit ;
where C is cash flow, Q is market value of assets over book value of assets, X is the set
of additional controls including stock ownership (as a percentage of total shares
outstanding), and total number of vested options (normalised by total number of
shares outstanding), firm size, and corporate governance (number of outside directors
who are currently CEOs in other companies). D is the press-based overconfidence
measure, TOTALdummy, used as a simple managerial fixed-effect. To control for a
potential press bias towards positive portrayal, we include the total number of articles
mentioning the CEO during the sample period, TOTALmentions, as an additional
control. We also include year- and firm-fixed effects as well as (year)*(cash flow)
interactions. As in Malmendier and Tate (2005a), we further split the sample into

7
To address this concern in the mergers context (Malmendier and Tate, 2005b), we employ a
duration model, restricting the analysis to CEO-firm years up to the first merger (if any).

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 Does Overconfidence Affect Corporate Investment? 655

quintiles from ‘least constrained’ to ‘most constrained’ using lagged values of the
Kaplan-Zingales index. The overconfidence theory predicts that overconfident CEOs
in the most constrained quintile display positive and significant investment-cash flow
sensitivity. The results, reported in Table 1, confirm these predictions.
In Malmendier and Tate (2005b), we provide related evidence on the real effects of
overconfidence. We find that our measures predict heightened managerial acquisitive-
ness, particularly in the absence of financial constraints, and show that overconfidence
can explain a significant portion of acquiring shareholder value lost in merger deals.
The investment and merger results imply that financing decisions are also affected by
overconfidence. In Malmendier et al. (2005), we identify directly the financing channel,
showing that overconfidence induces a preference for internal over external financing
and, conditional on external financing, a preference for debt of equity. Overconfidence
thus has the potential to explain both the low-leverage puzzle and pecking-order type
behaviour, as well as the variation of these patterns across firms and within firms
(Graham, 2000; Shyam-Sunder and Myers, 1999; Myers and Majluf, 1984).

4. Implications for Corporate Governance

The possibility of executive overconfidence alters basic conclusions about incentive

mechanisms. If CEOs are too optimistic about the value they can generate, then stock
and options are not helpful in improving corporate decision-making. Overconfident
CEOs do not need incentives to maximise the market value of the firm’s equity – that
is what they believe they are doing already. Options could even push them towards
risk-loving behaviour and investments which are riskier (and lower NPV) than share-
holders prefer, especially given that the CEOs already overestimates the expected
value of those gambles.
Other incentive devices may work better to root out overinvestment than stock and
options. One example is debt. If cash is tied up for debt repayments and the capacity
for senior debt is exhausted, the CEO would need to issue risky debt or equity to
finance projects. Given that overconfident CEOs perceive their firms to be under-
valued, the pre-existing debt will curtail the tendency to overinvest.
More generally, requiring outside approval could counterbalance CEO overconfi-
dence. The ‘outsider’ could be a vigilant board. The company charter typically
specifies a dollar amount beyond which the board has to approve any investment.
Lowering the threshold may be a sensible strategy to combat overinvestment due to
overconfidence (if boards competently fulfil their monitoring function). An active
board that is aware of the firm’s investment opportunities could also encourage the
CEO to undertake value-creating projects he may leave on the table when financing
constraints are tight. Obviously, limits on rationality and expression of social prefer-
ences may affect not only managers but also board members. While overconfidence
about the firm’s projects may be less likely in external board members (who are not
personally hand-picking and designing the projects) than in CEOs, other biases, like
escalation of commitment, could affect board decisions as well.
Another important issue is the selection of board members. Do CEOs look for the
most able and knowledgeable people? Or do they install yes-men (and maybe parti-
cularly so when they are overconfident)? The fundamental problem in evaluating
board quality is that the literature has yet to come up with a reliable measure of
high-quality boards. Sample limitations – there are still few panel data sets with a long
enough time series to analyse changes in corporate governance within firms – and
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656
Table 1
Investment policy and press perception.
The dependent variable in the regressions is Investment, defined as firm capital expenditures and normalised by capital at the beginning of the year. Cash
flow is earnings before extraordinary items plus depreciation and is normalised by capital at the beginning of the year. Q is the market value of assets
over the book value of assets and is taken at the beginning of the year. Stock ownership is the fraction of company stock owned by the CEO and his
immediate family at the beginning of the year. Vested options are the CEO’s holdings of options that are exercisable within 6 months of the beginning of
the year, as a fraction of common shares outstanding. Vested options are multiplied by 10 so that the mean is comparable to stock ownership. Size is the
natural logarithm of assets at the beginning of the year. Corporate governance is the number of outside directors who currently serve as CEOs of other
companies.

Ulrike Malmendier and Geoffrey Tate

TOTALmentions are the total number or articles in Business Week, New York Times, Wall Street Journal, The Economist, and Financial Times mentioning
the CEO during the sample period. TOTALdummy is a dummy variable equal to 1 if the total number of articles referring to the CEO as ‘confident’ or
‘optimistic’ exceeds the number of articles referring to him/her as ‘reliable’, ‘cautious’, ‘practical’, ‘frugal’ or ‘steady’. Firms are classified according to
values of the Kaplan-Zingales index at the beginning of the year, where the highest quintile contains the most constrained subsample. All standard errors
are robust to heteroskedasticity and arbitrary within-firm serial correlation.

Least constrained – – – – – – – – – – –> Most constrained

OLS: quintile 1 OLS: quintile 2 OLS: quintile 3 OLS: quintile 4 OLS: quintile 5

Cash flow 0.6496 0.5151 1.023 0.0369 1.0788

(1.95)* (0.94) (2.25)** (0.07) (2.08)**
Q 0.0468 0.0202 0.0695 0.0714 0.1575
(0.54) (0.73) (1.98)** (1.61) (4.12)***
Stock ownership (%) 0.1631 0.1324 0.0539 0.64 0.7617
(0.39) (0.73) (0.30) (1.92)* (2.06)**
Vested options 0.7366 0.1807 0.2361 0.3493 0.0151
(1.09) (0.44) (1.38) (1.00) (0.07)
Size 0.0541 0.0512 0.0184 0.027 0.0477
(1.05) (1.12) (0.83) (1.05) (1.21)
Corporate governance 0.0097 0.0129 0.0039 0.0046 0.0009
(0.46) (0.89) (0.65) (0.64) (0.08)
(Q)*(Cash flow) 0.0529 0.0347 0.0358 0.007 0.129
(0.74) (0.94) (0.45) (0.06) (1.33)
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(Stock ownership)*(Cash flow) 0.4374 0.4131 1.0985 1.2733 0.2707

Does Overconfidence Affect Corporate Investment?

(0.68) (0.55) (1.39) (1.41) (0.57)
(Vested options)*(Cash flow) 0.5652 0.15 0.1875 1.4651 0.2098
(1.23) (0.49) (0.34) (2.32)** (0.61)
(Size)*(Cash flow) 0.028 0.0135 0.0548 0.0182 0.0109
(0.56) (0.20) (1.17) (0.26) (0.15)
(Corporate governance)*(Cash flow) 0.0223 0.0392 0.0375 0.0957 0.0535
(0.74) (0.89) (1.46) (2.24)** (1.04)
TOTALmentions 0.0001 0.0002 0.0001 0.0004 0.0001
(0.50) (0.62) (0.48) (0.99) (1.14)
(TOTALmentions)*(Cash flow) 0.0002 0.0002 0.0003 0.0004 0.0002
(0.69) (0.31) (1.08) (0.78) (1.36)
TOTALconfident 0.0474 0.0153 0.0233 0.0308 0.0049
(0.60) (0.29) (0.78) (1.51) (0.18)
(TOTALconfident)*(Cash flow) 0.0312 0.1023 0.1278 0.0895 0.2736
(0.23) (0.72) (1.43) (0.77) (2.06)**
Firm fixed effects yes yes yes yes yes
Year fixed effects yes yes yes yes yes
(Year fixed effects)*(Cash flow) yes yes yes yes yes
Observations 723 724 723 724 723
Adjusted R-squared 0.55 0.79 0.91 0.82 0.76

T-statistics in parentheses. * significant at 10%; ** significant at 5%; *** significant at 1%

657
658 Ulrike Malmendier and Geoffrey Tate

endogenous firm response make progress in this area challenging. Monetary incen-
tives may not be all that matters. The ability to speak the language of the CEO and/or
the other board members – or even other-regarding preferences – may be far better
determinants of directors’ monitoring quality. The behavioural perspective may help
the quest for better measures of ‘who speaks up in the boardroom’.

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