CEO Overconfidence and Long‐Term Performance Following R&D Increases

• Author: Po‐Hsin Ho,Keng‐Yu Ho,Sheng‐Syan Chen
• DOI: http://doi.org/10.1111/fima.12035
• Date: 01 June 2014
• Published date: 01 June 2014

CEO Overconfidence and Long-Term

Performance Following R&D Increases

Sheng-Syan Chen, Keng-Yu Ho, and Po-Hsin Ho∗

We examine the relation between Chief Executive Officer (CEO) overconfidence and significant

increases in research and development (R&D) expenditures. Although prior studies reveal a

significantly positive market reaction to increases in R&D expenditures in both the long and

short run, we find that long-run stock performance is positive only for firms whose CEOs are not

overconfident. Our findings, which may be attributable to overinvestment and the overestimation

of future cash flows, imply that R&D resulting from overconfident behavior does not provide any

value to firms.

Many prior studies in finance report that overconfident Chief Executive Officers (CEOs) affect

the investment decisions of their firms. The theory regarding CEO overconfidence essentially

stems from a prominent stylized fact, namely, the “better-than-average” effect in the psychology

literature (Larwood and Whittaker, 1977; Svenson,1981; Alicke, 1985). Psychology studies sug-

gest that people generally overestimate their wisdom and skills relative to an average benchmark.

As a result, they are more likely to attribute positive outcomes to their own actions and negative

outcomes to bad luck or external factors.

Several prior studies attribute overconfidence to three main factors: 1) the illusion of control,

2) a high degree of commitment to specific results, and 3) abstract reference points (Weinstein,

1980; Alicke et al., 1995). These three factors trigger overconfidence and are closely related to

the role of the CEO and the characteristics of corporate investment decisions. Specifically, CEOs,

as the highest ranking officer in their companies, believe that strategic outcomes are under their

control. In addition, they are typically highly committed to better performance of the firm and

thus are driven to produce particular outcomes. Moreover, corporate investment decisions are

complicated, and their success can be affected by various factors. With such abstract reference

points, CEOs may overestimate their ability to select profitable investment projects.

Focusing on the overestimation of future cash flows, Malmendier and Tate (2005) propose a

simple model to demonstrate empirically that managerial overconfidence may cause corporate

investment distortions. They find that the sensitivity of investment to cash flowsis strongest when

discernible overconfidence is present. Malmendier and Tate (2008) suggest that overconfidence

among CEOs may help to explain merger and acquisition (M&A) decisions. Since overconfident

We are grateful to Ulrike Malmendier for providing us with the CEO overconfidence data and William Christie, Marc

Lipson (Editor), and especially an anonymous reviewer for constructive comments. The study has benefitted from

comments from the conferenceparticipants at the 2010 NTU International Conference on Finance, the 6th International

Conferenceon Asian Financial Markets, PKU/NTU Finance Conference,M acao InternationalSymposium on Accounting

and Finance, the 2012 EFA Meeting, the 2012 AsianFA Meeting, and the 2012 FMA Annual Meeting, as well as seminar

participants at National Chengchi University, University of Reading, National Cheng Kung University, Chongqing

University, and National Taiwan University.

∗Sheng-Syan Chen is a Professor in the Department of Finance at National Taiwan University, Taipei, Taiwan.Keng-Yu

Ho is an Associate Professor in the Department of Finance at National Taiwan University, Taipei, Taiwan. Po-Hsin Ho

is an Assistant Professor in the Department of Finance,National United University, Miaoli, Taiwan.

Financial Management •Summer 2014 •pages 245 - 269

246 Financial Management rSummer 2014

CEOs tend to overestimate their ability to generate higher returns, they pursue value-destroying

M&As and pay excessive amounts for target companies.

Malmendier and Tate (2008) find that overconfident CEOs are, in general, more likely to

engage in M&As. Specifically, they find that the probability of a CEO making an acquisition is

65% higher if the CEO is regarded as overconfident. The probability of a merger is greater if

the merger involves diversification and does not require external f inancing. When compared to

merger announcements by non-overconfident CEOs, the market reaction to announcements by

overconfident CEOs is significantly negative.

Ben-David, Graham, and Harvey (2013) provide an alternate theoretical framework for the

analysis of the relation between managerial overconfidence and corporate policies. They suggest

that overconfident managers either tend to underestimate the volatility of their firms’ future cash

flows or overweight private signals relative to public information. They posit and find that based

on an empirical examination of survey data from hundreds of Chief Financial Officers (CFOs),

overconfident managers tend to invest more than less confident managers.

Goel and Thakor (2008) propose a theoretical model on the relations among overconfidence,

CEO selection, and corporate governance. The study focuses on three types of CEOs: 1) ex-

cessively overconfident, 2) moderately overconfident, and 3) excessively diffident CEOs. Their

model provides an explanation of the paradox that overconfident managers are more likely to

be promoted to CEO, but later forced to leave the office. In addition, they predict that when

compared to moderately confident CEOs, excessively overconfident and excessively diffident

CEOs face a greater likelihood of forced turnover. Goel and Thakor (2008) further demonstrate

that excessively overconfident and excessively diffident CEOs ultimately reduce the value of the

firm as a result of overinvestment and underinvestment, respectively. In a subsequent empirical

examination, Campbell et al. (2011) find strong support for Goel and Thakor’s (2008) model.

Other empirical studies focusing on relevant research include the following. Malmendier, Tate,

and Yan (2011) examine the relation between overconfidence and major financial decisions. In

addition, Billett and Qian (2008) study the linkage betweenoverconfidence and M&A frequencies,

and Liu and Taffler (2008) focus on the relation between overconfidence and M&A decision

making. Finally, Hribar and Yang (2010) find that overconfidence increases the issuance of overly

optimistic management earnings forecasts, thereby leading to greater earnings management.

Although, as noted,signif icant prior research investigatesissues related to CEO overconfidence

and associated financial decisions, few studies examine CEO overconfidence and research &

development (R&D) expenditures. To the best of our knowledge, only two studies address a

similar topic. Galasso and Simcoe (2011) and Hirshleifer, Low, and Teoh (2012) both examine

the association between CEO overconfidence and CEO behavior with regard to innovation and

find that overconfident CEOs are more likely to move their firms toward innovation.These studies

also examine the relation between CEO overconfidence and patent citations and provideevidence

that overconfident CEOs obtain greater numbers of patents and patent citations.

Our study contributes to the extant literature by combining CEO overconfidence and R&D

investment decisions, but differs from the analysesof Galasso and Simcoe (2011) and Hirshleifer

et al. (2012) in two important ways. First, we investigate the relation between CEO overconfi-

dence and the effects of significant increases in R&D expenditures. Both Galasso and Simcoe

(2011) and Hirshleifer et al. (2012) examine the general relation between overconfident CEOs

and their innovation behavior. Because a firm is likely to increase its R&D expenditures as it

grows, regular R&D increases may not have an economical impact on the firm. Therefore, we

specifically focus only on firms that increase their R&D by an economically significant amount.

Additionally, we examine long-run abnormal stock returns and operating performance following

significant increases in R&D expenses from the perspective of CEO overconfidence. Neither