Bright Sides and Dark Sides of Overconfidence
28 important questions on Bright Sides and Dark Sides of Overconfidence
In general CFO forecasts have wider confidence intervals for long-term forecasts because. give 2 reasons here
CFOs forecast wider confidence intervals for long-term forecasts because they (1) allow for larger mistakes and parameter uncertainty over longer horizons, and (2) seem to believe that volatility will increase in the future.
What can be said about Miscalibration regarding own-firm projects
Miscalibration and corporate policies.
what can we say about long term overprecision and what can we say about short term calibration?
Short-term miscalibration is associated with moderate increase in leverage
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Is there a causal effect of miscalibration?
Do miscalibrated CFOs make bold decisions, or do firms with bold strategies make CFOs miscalibrated?
Test: examine the effect of miscalibrated CFO who take office in a firm.
To summarize Ben-David, Graham and Harvey give 3 summarizing results
2 CFO overprecision is related to corporate decision making.
3 Implications for investors, regulators, and other stakeholders.
Graham (1999) survey of CFOs Two-thirds of CFOs state their stock is undervalued.
what percentage wise were the responses from all the CFOs?
for undervalued, correctly valued, overvalued
Graham (1999) survey of CFOs
Overconfidence based mainly on the better-than-average effect and optimism.
Overconfident CEOs systematically overestimate the return to their investment projects and the value of their company.
name 2 Implications for corporate investments:
-CEOs may underinvest, if they do not have sufficient internal funds. They are reluctant to issue new equity because they perceive the stock of their company to be undervalued by the market
For Graham (1999) name 2 explanations or hypotheses:
1 The investments of overconfident CEOs are more sensitive to cash flows than the investment of CEOs who are not overconfident.
2 The investment–cash flow sensitivity of overconfident CEOs is more pronounced in equity-dependent firms.
Hall and Murphy (2002):
Exercise price of $30.
CEO risk aversion equal to 2 or 3.
how does risk aversion translate.
Hall and Murphy (2002):
Name 3 overconfidence measures .
2 Longholder: CEOs are classified as overconfident if they ever hold an option until the last year of its duration. - 85 out of 661 CEOs.
3 Net buyer: CEOs are identified as overconfident if they were net buyers of company equity during their first five years in the sample. - 97 out of 158 CEOs.
Alternative interpretations of the measures.
name 5 alternative interpretations of the measures:
2 Signaling: - Does not predict investment-cash flow. - Net buyer measure for two disjoint periods of time.
3 Risk tolerance (lower risk aversion): - Less risk averse CEOs should borrow more and be less sensitive to cash flows.
4 Tax reasons.
5 Procrastination: - CEOs trade on their personal portfolios. - CEOs engage in M&A activity. - Inertia does not predict purchasing additional stocks (net buyer).
Overconfidence and corporate investments.
what paper is this from?
what is the dependent variable?
what can we say about levels of overconfidence in personal portfolio decision.
what are the effects of being a longholder vs a net buyer measure?
CEOs who demonstrate a higher level of overconfidence in their personal portfolio decisions also exhibit a higher sensitivity of corporate investment to cash flow.
Similar results for Longholder and Net buyer measures.
How do we identify financial constraint?
what are the effect of overconfidence on these investment to cash flow?
what can we say about different documentation for credit ratings?
The effect of overconfidence on the sensitivity of investment to cash flow is significant only for the most equity-dependent firms.
Also documented among the youngest firms, the smallest firms, firms that pay the fewest dividends, and the sample of firms with low credit ratings.
Malmendier and Tate (2008). Malmendier and Tate 2008: is on overconfidence and M en A.
Overconfident CEO make value-destroying mergers.
what are 4 reasons why these overconfident CEO`s make value-destroying mergers?
2 They are more likely to make (bad) diversifying mergers.
3 The effects are strongest if CEOs have access to internal financing.
4 The market reaction is significantly more negative for mergers conducted by overconfident CEOs.
Malmendier and Tate (2008) - market reaction.
what is a market reaction by merger bids.
what does longholder CEO bids trigger?
Bids of Longholder CEOs always trigger a negative average reaction.
Conclusion: CEO overconfidence and corporate policies Alternative explanation of corporate investment distortions.
Decisions by managers with biased views about their company (projects) can result in both overinvestment and underinvestment:
name 4 ways in which this manifests itself.
Implement projects with excessive risk.
Implement projects with negative NPV.
Shun profitable projects with positive NPV
Bright sides of CEO overconfidence: Hirshleifer, Low and Teoh (2012).
what is the overconfidence puzzle?
what are the 2 hypotheses that are paired with this?
what are 2 potential effects on performance?
Hypothesis: Firms with overconfident managers accept greater risk, invest more heavily in innovative projects, and achieve greater innovation.
- Overestimate expected cash flows.
- Underestimate risk.
Potential effect on performance:
Negative: overconfident managers undertake projects with low expected payoff.
Positive: overconfident managers accept good but risky projects, avoided by rational managers.
CEO overconfidence and stock return volatility.
what is a findings with respect to risky projects?
what can be said about daily return volatlity and overconfident CEO`s?
Press-based measure: having an overconfident CEO is associated with daily return volatility being higher by 20 basis points, which annualizes to 3% per year
Hirschleifer, Low and Teoh (2012):
CEO overconfidence and R&D expenditures Input: Overconfident managers increase innovative investment (R&D expenditures).
- Overconfident managers are associated with a 9% to 28% higher patent count.
- Overconfidence increases Qcitation count by about 17%-40% and TTcitation count by 11%-20%.
Hirschleifer, low and Teoh(2012)
Is there a causal effect of CEO overconfidence?
give 2 possible interpretations
1 Overconfidence causes managers to overestimate their prospects for success in risky endeavors such as innovation.
2 Firms with opportunities for innovative projects appoint overconfident CEOs.
Hirschleifer, low and Teoh (2012).
Is there a causal effect of CEO overconfidence?
what can we say with respect to overconfidence
when are CEO overconfidence and time-varying firm characteristics strongest?
overal what is the results of overconfidence relates to volatility , r en d expenditures and innovative output.
Overconfidence is persistent, while firm growth opportunities vary over time.
Matching effects between CEO overconfidence and time-varying firm characteristics are likely to be strongest when the CEO is first appointed.
Results: Overconfidence continues to be positively related to volatility, R&D expenditures and innovative output.
CEO overconfidence and firm value.
Overconfident managers are more willing to undertake risky but valuable innovation:
-what can we say with respect to the industry P/E ratio
- about the Tobins Q measure of firm value
- overconfidence and growth?
- Tobin’s Q measures firm value.
- Overconfident are able to transform growth opportunities into firm value.
Summary Puzzle:
Why firms employ overconfident managers and give them leeway to follow their beliefs in making major investment and financing decisions?
give 3 reasons
2 Greater innovative output is achieved only in innovative industries.
3 In innovative industries, overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value.
Effects increasing overconfidence Agents can become more overconfident over time due to: name 3 reasons
2 Illusion of knowledge.
3 Illusion of control.
Illusion of knowledge. explain this
and what are investor susceptible to?
Investors have access to vast quantities of data, but lack training and experience as compared to professional money managers.
Investors susceptible also to cognitive dissonance.
What is illusion of control?
name 3 Attributes that foster an illusion of control:
Choice.
Task familiarity.
Competition.
Active involvement.
What are experience effects?
name 2 application of experience effects
When making decisions, we should take account of all past data... But some people pay excessive attention to data they have personally experienced.
Applications:
1 Household portfolio choice. Malmendier and Nagel (2012): household decisions about how much to invest in the stock market can be explained by the stock returns they have personally experienced.
2 Corporate financial policies. Malmendier, Tate and Yan (2011): CEOs who have lived through economic crises are more conservative in their use of debt.
Behavioral biases related to experience effects.
Agents can also create a biased interpretation of their experience:
name 3
2 Hindsight bias: The tendency of people to believe, after an event has occurred, that they predicted it before it happened.
3 Availability bias: When judging the probability of an event people search their memories for relevant information. - Only successful traders appear in financial media. - The effect of advertisements: E*TRADE baby commercials.
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