CEO Overconfidence and Corporate Investment∗

We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity-dependent firms. ∗Malmendier is at Stanford University and Tate is at the University of Pennsylvania. We are indebted to Brian Hall and David Yermack for providing us with the data. We are very grateful to Jeremy Stein for his invaluable support and comments. We also would like to thank Philippe Aghion, George Baker, Stefano DellaVigna, Edward Glaeser, Rick Green (the editor), Brian Hall, Oliver Hart, Caroline Hoxby, Dirk Jenter, Larry Katz, Tom Knox, David Laibson, Andrei Shleifer, one anonymous referee and various participants in seminars at Harvard University, MIT, University of Chicago, Northwestern University, University of California Berkeley, Stanford University, University of California Los Angeles, CalTech, Yale University, University of Michigan, Duke University, New York University, Columbia University, Wharton, London School of Economics, Centre de Recherche en Économie et Statistique (Paris), Centro de Estudios Monetarios y Financieros (Madrid), Ludwig-Maximilians-Universität (Munich), the annual meeting of the American Finance Association, the annual meeting of the Eastern Economics Association, the Russell Sage Summer Institute for Behavioral Economics, and the summer workshop of the Stanford Institute for Theoretical Economics for helpful comments. Mike Cho provided excellent research assistance. Malmendier acknowledges financial support from Harvard University (Dively Foundation) and the German Academic Exchange Service (DAAD). In this paper, we argue that personal characteristics of CEOs in large corporations lead to distortions in corporate investment policies. In particular, we study the investment decisions of CEOs who overestimate the future returns of their companies, measured by a failure to divest company-specific risk on their personal accounts. We find that overconfident CEOs have a heightened sensitivity of corporate investment to cash flow, particularly among equitydependent firms. The two traditional explanations for investment distortions are the misalignment of managerial and shareholders interests (Jensen and Meckling (1976); Jensen (1986)) and asymmetric information between corporate insiders and the capital market (Myers and Majluf (1984)). Both cause investment to be sensitive to the amount of cash in the firm. Under the agency view, managers overinvest to reap private benefits such as “perks,” large empires, and entrenchment. Since the external capital market limits the extent to which managers can pursue self-interested investment, an influx of cash flow enables the manager to invest more and increases investment distortions. Under asymmetric information, the managers themselves (who act in the interest of shareholders) restrict external financing in order to avoid diluting the (undervalued) shares of their company. In this case, cash flow increases investment, but reduces the distortion. The empirical literature, starting with Fazzari, Hubbard, and Petersen (1988), confirms the existence and robustness of investment-cash flow sensitivity after controlling for investment opportunities. While most of the literature relates investment-cash flow sensitivity to imperfections in the capital market, this interpretation remains controversial (Kaplan and Zingales (1997), (2000); Fazzari, Hubbard, and Petersen, (2000)). We propose an alternative explanation for investment-cash flow sensitivity and suboptimal investment behavior. Rather than focusing on firm-level characteristics, we relate corporate investment decisions to personal characteristics of the top decision-maker inside the firm. Building on Roll (1986) and Heaton (2002), we argue that one important link between investment levels and cash flow is the tension between the beliefs of the CEO and the market about the value of the firm. Overconfident CEOs systematically overestimate the return to their investment projects. If they have sufficient internal funds for investment and are not disciplined by the capital market or corporate governance mechanisms, they overinvest relative to the firstbest. If they do not have sufficient internal funds, however, they are reluctant to issue new equity because they perceive the stock of their company to be undervalued by the market. As a result, they curb their investment. Additional cash flow provides an opportunity to invest closer to their desired level. Our overconfidence story builds upon a prominent stylized fact from the social psychology literature, the “better-than-average” effect. When individuals assess their relative skill, they tend to overstate their acumen relative to the average (Larwood and Whittaker (1977); Svenson (1981); Alicke (1985)). This effect extends to economic decision-making in experiments (Camerer and Lovallo (1999)). It also affects the attribution of causality. Because individuals expect their behavior to produce success, they are more likely to attribute good outcomes to their actions, but bad outcomes to (bad) luck (Miller and Ross (1975)). Executives appear to be particularly prone to display overconfidence, both in terms of the better-than-average effect and in terms of “narrow confidence intervals” (Larwood and Whittaker (1977); Kidd