Darryl Laws

 The analysis of overconfidence relates several branches of behavioral economics and psychology literature. First, extensive amount of experimental literature documents the tendency of individuals to consider themselves above average on positive characteristics (Alicke, 1995; Alicke, 1985; Svenson, 1981). Example, Svenson demonstrates that the vast majority of subjects rate their driving skills as above average. Svenson’s finding has been replicated numerous times in various countries and with respect to various IQ or skill related outcomes like driving. When asking a sample of entrepreneurs about their chances of success, Cooper (1988) found that 81% answered between 0 and 30% (with 33% attaching exactly zero probability to failure). However, when asked the odds of any business like theirs failing, only 39% of them answered between 0 and 30%. Larwood and Whittaker (1977) find that corporate executives are particularly prone to this form of self-serving bias. The better than average effect also affects the attribution of causality. Because individuals expect their behavior to produce success, they attribute outcomes to their actions when they succeed and to bad luck when they fail (Miller and Ross, 1975; Feather and Simon, 1971). This self-serving attribution of outcomes reinforces overconfidence. Miller and Ross (1975) found; 1) that overconfident CEOs are more likely to pursue acquisitions when their firms have abundant internal resources, 2) overconfident CEOs are significantly more likely than other CEOs to undertake a diversifying merger and 3) overconfident CEOs were observed to use cash on the balance sheet to finance their mergers more often than other CEOs who leverage their company’s stock value as if it were a check book.

Malmendier and Tate (2008) examine the extent to which over-confidence can help to explain merger / acquisition decisions and various characteristics of the deal itself. They find that overconfident CEOs are; 1) more likely to pursue acquisitions when their firms have abundant internal resources, 2) are significantly more likely than other CEOs to undertake a diversifying merger and 3) that overconfident CEOs use cash to finance their mergers / acquisitions more often than rational CEOs. They have developed a unique model for CEO overconfidence that shows the impact of overconfidence on merger / acquisition decisions. Their model empirically and quantitively test the predictions on a data set of large U.S. companies from 1980 to 1994. They use the CEOs’ personal portfolio decisions to measure overconfidence, they find that overconfident CEOs conduct more mergers / acquisitions and, in particular, more value-destroying mergers / acquisitions. They prognosticate that these effects are most pronounced in firms with abundant cash or untapped debt capacity. Furthermore, the market’s assessment of overconfident CEOs, reflected by press coverage in major business publications and the stock price reaction to merger / acquisition announcements, corroborates their overconfidence theory.

Darryl Laws