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Are Overconfident CEOs Better Innovators?
- 1. 1 Are Overconfident CEOS BetterInnovators? David Hirshleifer Angie Low Siew Hong Teoh Journal of Finance 2012
- 2. 2 Overconfidence “...perhaps the mostrobust finding in the psychology of judgment is that people are overconfident.” Debondt & Thaler (1995)
- 3. 3 What is overconfidence? •Tendency to think one is better than – One actually is – Average – One is viewed by others on some relevant dimension – Ability – Judgment – Prospect for success • For our purpose – Overestimate the expected payoffs of uncertain endeavors
- 4. 4 Variation in Overconfidence •Strong and stable differences in degree of overconfidence across individuals – Biais et al. 2005, Klayman and Burt 1998, Klayman et al. 1999 • Overconfidence also varies with: – Gender • Barber and Odean 2001, Biais et al. 2005 – Culture • Lee et al. 1995, Koellingera, Minnitic and Schaded 2007 – Whether individual is expert in decision domain • Wagenaar and Keren 1986 • Substantial differences in overconfidence of managers – CEOs • Malmendier and Tate, 2005, 2008 – CFOs • Ben-David, Graham, and Harvey, 2010
- 5. 5 Link to Innovation •Greater overconfidence – In difficult tasks (Hard-Easy Effect) – In settings with ambiguous and deferred feedback (Einhorn 1980) • R&D activities appealing for considering overconfidence effects – Highly risky and challenging – Outcome feedback deferred – Talent- and vision-sensitive
- 6. 6 R&D • Immediate expensingreduces earnings – Create reputational risk to manager – Potentially constrains CEOs – Optimism of overconfident CEOs constrains them less
- 7. 7 Research Questions Do overconfidentCEOs (who overestimate expected project payoffs) • Take on riskier projects? • Invest more in R&D? • Achieve more innovations? – Greater patent counts – Greater patent citations • Achieve more innovative success controlling for amount of investment in R&D? Better Innovators?
- 8. 8 Relation to Literature •Overconfidence linked to investment – Capital Expenditures • Malmendier & Tate JF 2005 – Acquisitions • Malmendier & Tate JFE 2008 • R&D different type of investment – Highly risky, challenging, vision-related, deferred outcome, so especially suited to find overconfidence effects – Outcomes are measurable as patents & citations, so can test whether overconfidence leads to more effective innovation
- 9. 9 Literature, contd. • Firmshire overconfident managers – Malmendier & Tate (2005, 2008) – Ben-David, Graham and Harvey (2010) – Graham, Harvey, and Puri (2010) • Puzzling if overconfidence implies suboptimal investments – More negative acquisition announcement effects (Malmendier & Tate 2008) • Our findings suggest a possible solution to the overconfident manager puzzle – Overconfident CEOs are better innovators
- 10. 10 Other Effects ofManagerial Confidence Overconfident Managers • Less external finance, less equity issuance – Malmendier, Tate, and Yan (2010) • More aggressive financing and other managerial policies – Ben-David, Graham, and Harvey (2010) • Issue more optimistic forecasts, More earnings management – Hribar and Yang (2010) • More earnings management and financial fraud – Schrand and Zechman (2010)
- 11. 11 Summary of Results OverconfidentCEOs • Invest more heavily in R&D • Take on greater risk (std. dev. of returns) • Achieve a greater total quantity of innovation as measured by patenting and citations. • Achieve greater innovative success after controlling for the level of R&D expenditure. • Achieve greater total patents and citations only in more innovative industries • Better able to exploit industry growth opportunities
- 12. 12 Data Sources • Overconfidencemeasures – Execucomp for options compensation data – Factiva for text of press articles about CEO • Innovation measures – Compustat for R&D spending – NBER Patent Database (1976-2006) • 2.3 million patents, 23.6 million citations • CRSP, Compustat, and Execucomp for other variables
- 13. 13 Data • Execucomp firms –Sample period 1993-2003 – Exclude financials and utilities • 2,557 CEOs, 9,807 firm-year observations – 8,939 options-based firm-year obs – 7,762 press-based firm-year obs.
- 14. 14 Innovation Measures • R&Dspending • Patent count in application year • Citation count – Measure forward citations – Adjusted to take into account truncation bias (newer patents have less time to collect citations) – Qcitation count: Weighting index empirically estimated • Hall, Jaffe, and Trajtenberg, 2001, 2005 – Ttcitation count: Weighted by the average citation count of all patents in the same technology class and in the same year
- 15. 15 Options-Based Overconfidence Measure •Malmendier & Tate (2005 and 2008), Campbell, Johnson, Rutherford, and Stanley (2011) • Indicator variable – 1 if overconfident, 0 otherwise • Overconfidence measured as overexposure of CEOs to the idiosyncratic risk of their firms through their holdings of options and stock. • A CEO is defined as overconfident once she postpones the exercise of vested options that are at least 67% in the money. • Persistent personality trait (Malmendier & Tate 2005) – Using option measure, once identified as overconfident, remains so through the sample period.
- 16. 16 Press-based Overconfidence Measure •Malmendier & Tate (2005, 2008) • Factiva search for articles referring to the CEO in New York Times, Business Week, Financial Times, Wall Street Journal, The Economist, Fortune, and Forbes • Confidence-related words – ‘confident’, ‘optimistic’, and variants • Non-confidence related words (pessimistic, reliable, steady, practical, conservative, frugal, cautious, gloomy, and variants, and negated confidence-related words) • Overconfident if number of articles with confidence- related words > number of articles with non- confidence related words in a given year • Control for TotalMention – # of articles mentioning CEO
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- 18. 18 Descriptive Statistics • Table2 • Overconfident CEOs – Higher stock return volatility – Higher R&D/Assets – Higher Patent Applications, total citation count (both raw and adjusted) – Press-based (79 vs. 20 patents) – Controls • Firm characteristics (smaller size, higher growth, higher profitability, lower leverage, lower cap intensity, more cash) • Manager characteristics (longer tenure, higher Delta, higher Vega))
- 19. 19 Overconfidence and Risk-Taking Table3 • Overconfidence – Higher stock return % volatility (std. dev. daily stock returns) • Year & 2-digit SIC fixed effects, Std err cluster at firm level • Controls – Firm characteristics • Log(sales), Log(PPE/emp), Stock return, Tobin’s Q,Sales growth, ROA, Book leverage, Cash – Manager characteristics • Tenure, Delta (Manager pay sensitivity to firm value) and Vega (Manager pay sensitivity to firm volatility) – TotalMention for press-based
- 20. 20 Overconfidence and Risk-Taking Table3 • Options-based Overconfidence – Increases volatility by 6 bp (daily), 1% (annual) – Comparison: doubling firm sales (size measure) decreases volatility by 2.5% per year. • Press-based Overconfidence – Increases volatility by 20bp (daily), 3% (annual)
- 21. 21 Overconfidence and R&DExpenditures Table 4 • Dependent variable: R&D/Assets • Overconfident CEOs higher R&D • Options-based Overconfidence increases R&D by 0.4% to 0.8% of assets. – Mean R&D/Assets: 2.86% – An increase of 27% relative to this mean • Press-based Overconfidence increases R&D by 1% of assets. – Mean R&D/Assets: 3.72% – An increase of 27% relative to this mean
- 22. 22 Overconfidence and patentingactivity Table 5 • Dependent variable Log (1 + Patent) • Overconfident CEOs higher Patents • Options-based Overconfidence increases patent count by 9% to 11% • Press-based Overconfidence increases patent count by 27% to 29%
- 23. 23 Overconfidence and patentcitations Table 6 • Dependent variable: – Log(1 + Qcitation Count) – Log(1 + TTcitation Count) • Overconfident CEOs – higher citations • Options-based Overconfidence increases adjusted citations by 11% to 18%. • Press-based Overconfidence increases adjusted citations by 24% to 43%.
- 24. 24 Industry innovativeness Table 7 •Innovative industry: – Adjusted citations per patent for the industry > median average citations across all industries • Effect of confidence is only in innovative industries, stronger effects than in full sample • Overconfident CEOs – higher patent counts, higher citations but only in innovative industries
- 25. 25 Other Robustness Checks •Control for several lags of stock returns • Alternative options-based measure, require CEO to exhibit late exercise twice. • Press-based, delete articles with words relating to “project” that are within 20 words of confidence-related words. • Press-based, requiring at least one news article • Exclude self-cites • Delete firm-years with zero patents (citations) • Use 2-year lagged overconfidence meaures • Eliminate tech-boom (1998-2000)
- 26. Extensions • Table 8:Overconfident CEOs higher citation per patent, especially within innovative industries. • Table 9: Different degrees of overconfidence. 26
- 27. 27 Endogeneity (Matching of Firmto CEO) Table 10 • Firm characteristics (e.g., growth) vary over time Matching effects maximized when manager first hired • Keep firm-years with CEO tenure > 4 years (6 years) • Similar effects for stock return volatility, R&D, patent count, and patent citations • No sign that controlling for matching weakens the effect of confidence on innovation
- 28. 28 CEO overconfidence andinnovation effectiveness, Table 11 • Dependent variable: – Patent count and adjusted citation – Control for R&D • Divide into innovative industries vs non-innovative industries (to maximize power) • Overconfident CEOs – higher patent counts and citations within innovative industries • Smaller than coefficients w/o R&D control, but still substantial and positive Overconfident CEOs more effective innovators (for given R&D)
- 29. 29 CEO overconfidence andinnovation effectiveness • Overconfident CEOs more effective innovators • Finding offer possible solution to the overconfident CEO puzzle: – Why do firms hire overconfident CEOs, which has major effects (investment, acquisitions), at least in some contexts adversely (acquisitions)? • Impact on firm value? To avoid endogeneity issues, examine a more specific question: Does overconfidence allow firms to translate growth opportunities into realized firm value?
- 30. 30 CEO overconfidence andfirm value, Table 12 • Dependent variable: – 1-year ahead Tobin’s Q • Instrument for exogenous growth opportunities – Industry P/E (Bekaert et al. 2007) – Interact overconfidence measure with industry P/E • Stronger association between exogenous growth opportunities and firm value for overconfident CEOs – Results mainly within innovative industries
- 31. 31 Conclusion Overconfident CEOs • Takeon more risk • Invest more heavily in R&D • Achieve a greater total quantity of patents and patent citations – Especially in industries where innovations are important • Better innovators – Achieve greater innovative success after controlling for the level of R&D. – Contrast with past finding of adverse effects of overconfidence effects in other domains (e.g. acquisitions) – Suggests possible reason why firms continue to hire overconfident CEOs– the overconfident CEO puzzle • Overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value.
Editor's Notes
- #4 on some relevant characteristic (ability, …) Prospect for success – optimism In psych lit, overconfidence take a variety of forms. Don’t distinguish because tangential to our purpose. Diff aspects of overconf have similar implications for managers to bear risk and to undertake challenging projects. ‘better than average effect’ vs absolute overestimation of one’s own ability - induce a belief that one has a high relative position. “… the women are strong, the men are good-looking, and all of the children are above average.” Ability to identify good projects (judgmental overconfidence) Ability to manage challenging projects (overconfidence about implementation ability) - lead to overestimate the likelihood of success (overoptimism) Overest expected payoffs because overest belief accuracy, ability to generate action-relevant information (DST 1994), ability to control environment to bring about success
- #6 Consonant with self-image of manager who is strongly ego-driven or self-aggrandizing
- #12 Patenting may be less relevant for certain industries, either because they are less innovative, or because in these industries innovation does not result in patents. Innovative industries are where patents are important (measured as citations exceed median count in a given year)
- #13 Patent counts measure by applications during the year – only patents that are granted appear in database. Patents applied in 2004 and 2005 may not appear in the database by latest year 2006. Hall, Jaffe, and Trajtenberg (2001) suggest restrict period to end in 2003 and include year fixed effects in our regressions.
- #20 Deleted “firm risk” as a control– looked wrong.
- #32 Solution to the ‘overconfident CEO puzzle’