Biased interpretation of performance feedback: The role of CEO overconfidence

• DOI: http://doi.org/10.1002/smj.3138
• Date: 01 June 2020
• Author: Christian Schumacher,Wenjie Tang,Steffen Keck
• Published date: 01 June 2020

RESEARCH ARTICLE

Biased interpretation of performance feedback:

The role of CEO overconfidence

Christian Schumacher

1

| Steffen Keck

2

| Wenjie Tang

3

1

Department of Global Business and Trade, Vienna University of Economics and Business, Vienna, Austria

2

Department of Business Administration, University of Vienna, Vienna, Austria

3

Institute of Operations Research and Analytics, National University of Singapore, Singapore, Singapore

Correspondence

Christian Schumacher, Department of

Global Business and Trade, Vienna

University of Economics and Business,

Welthandelsplatz 1, 1020 Vienna,

Austria.

Email: christian.schumacher@wu.ac.at

Abstract

Research summary: This study examines how mana-

gerial biases in the form of overconfidence change the

interpretation of performance feedback and, conse-

quently, shape a firm's risk taking in response to it. Our

formal analysis suggests that CEO overconfidence is

associated with a lower willingness to increase firm risk

taking when facing negative performance feedback and

a higher willingness to decrease risk when facing posi-

tive feedback. An extension of our model also shows

that, when firms are operating close to their survival

level, the effects of CEO overconfidence will reverse. We

test our predictions empirically with a sample of

847 American manufacturing firms in the years 1992 to

2014. Our results are consistent with our hypotheses and

are robust to different empirical operationalizations of

CEO overconfidence.

Managerial summary: Managers evaluate the success

of their current business strategy through feedback in

the form of their firm's current financial results relative

to their own previous performance or that of their

peers. Our results show that overconfident CEOs inter-

pret information about the financial situation of their

firms more optimistically than non-overconfident

Received: 21 January 2019 Revised: 3 October 2019 Accepted: 23 November 2019 Published on: 25 February 2020

DOI: 10.1002/smj.3138

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2020 The Authors. Strategic Management Journal published by Wiley & Sons, Ltd. on behalf of Strategic Management Society.

Strat Mgmt J. 2020;41:1139–1165. wileyonlinelibrary.com/journal/smj 1139

CEOs, which in turn causes them to exhibit a less pro-

nounced reaction to both positive or negative perfor-

mance feedback. It is thus crucial that managers are

clearly aware of how their interpretations and reactions

to feedback are affected by their own deeply held per-

sonal beliefs and dispositions.

KEYWORDS

behavioral theory of the firm, CEO overconfidence, formal model,

performance feedback, risk taking

1|INTRODUCTION

Firms assess their financial performance by comparing it to specific aspiration levels, which

then in turn strongly shapes their risk-taking preferences. In particular, prior research in the

tradition of the behavioral theory of the firm posits that when organizations are performing

“close to a target they appear to be risk-seeking below the target, and risk-averse above it”

(Cyert & March, 1963, p. 228). Based on these predictions a large number of studies have

explored the direct link between firms' financial performances relative to aspirations and firm

risk taking (see, e.g., Gavetti, Greve, Levinthal, & Ocasio, 2012). However, a firm's response to

performance feedback will fundamentally depend on how key decision makers such as the

firm's CEO interpret this information rather than on an objective evaluation of firm perfor-

mance (e.g., Gavetti et al., 2012; Greve & Gaba, 2017; Jordan & Audia, 2012; Levinthal & Rerup,

2006), thus suggesting that reactions to performance feedback will frequently be distorted by

behavioral biases. At the same time, clearly showing the potential importance of such distor-

tions, a large body of literature (see, e.g., Picone, Dagnino, & Minà, 2014 for an overview) has

revealed that CEOs are frequently prone to exhibit excessively high levels of confidence in their

own managerial abilities which strongly affects their strategic decision-making. Interestingly, in

spite of this clear link, and the frequently noted importance of better understanding how execu-

tives' behavioral dispositions and biases shape their interpretation of different levels of firm per-

formance (Greve & Gaba, 2017; Jordan & Audia, 2012), the interplay between CEO

overconfidence and reactions of performance feedback has remained unexplored. In this article,

we address this gap by studying how CEOs' excessively high levels of confidence in their own

managerial skills might distort their interpretation of performance feedback, thereby causing a

clear difference between firms in their reactions to performance feedback depending on their

CEO's idiosyncratic level of overconfidence.

Following previous work on bounded rationality (see, e.g., Puranam, Stieglitz, Osman, &

Pillutla, 2015) and recent editorial calling for more rigorous analytical approaches to theory

building (Ethiraj, Gambardella, & Helfat, 2018), we address our research questions by develop-

ing a formal model which captures the different biasing effects of overconfidence on CEOs'

reactions to high and low levels of performance feedback. Our analysis suggests that CEO over-

confidence will be associated with a lower willingness to increase firm risk taking in the case of

negative performance feedback, and a higher willingness to decrease risk when receiving posi-

tive feedback. Moreover, consistent with recent work arguing that feedback interpretation can

1140 SCHUMACHER ET AL.