Wednesday, June 16, 2010

Overconfident CEOs are better

To be an entrepreneur, you should be confident and not risk-averse, given the high default rates. In a sense, you need to be out of the ordinary to take this kind of risk, and this is why there are so few entrepreneurs. Does this also translate to CEOs? In a sense they are entrepreneurs, but they are also employees. One can expect some of them to share the characteristics of entrepreneurs. How do their firms perform?

David Hirshleifer, Angie Low and Siew Hong Teoh take measures of over-confidence of CEOs and relate them to firm performance, in particular regarding to innovation. They measure over-confidence by looking at whether CEOs retain options beyond their vesting period and by analyzing press coverage about them, counting occurrences of particular words. They find that over-confident CEOs indeed do invest more in innovation and have more success as measured by patents. However, returns to R&D are much more volatile, and returns on assets are comparable to other firms.

One could then understand that firms that focus on growth and innovation would want to hire over-confident CEOs. Which leads us to the endogeneity issue. Removing recently hired CEOs, who would be best matches before the firm evolves, does not change results. The longer tenured CEOs have fashioned their forms to their image, giving us these results.

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