Working Paper: NBER ID: w10807
Authors: Ulrike Malmendier; Geoffrey Tate
Abstract: We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity-dependent firms.
Keywords: CEO Overconfidence; Corporate Investment; Cash Flow Sensitivity
JEL Codes: G31; G32; D21; D23; D82
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CEO overconfidence (M12) | overestimation of returns on investment projects (G31) |
| overestimation of returns on investment projects (G31) | overinvestment when internal funds are plentiful (G31) |
| CEO overconfidence (M12) | increased investment when cash flow is available (G31) |
| increased investment when cash flow is available (G31) | investment sensitivity to cash flow is significantly higher for overconfident CEOs (G40) |
| CEO overconfidence (M12) | reluctance to issue new equity (G32) |
| reluctance to issue new equity (G32) | curtailing investment when external financing is needed (G31) |
| CEO overconfidence (M12) | misperceptions about stock value (G41) |
| misperceptions about stock value (G41) | affects investment decisions (G11) |
| CEO characteristics (personal) (M12) | investment decisions (G11) |