Overconfidence , Investment Policy , and Executive Stock Options ∗

Managers make decisions on behalf of shareholders. In this context, financial economists have promoted executive stock options as a means to realign the incentives of managers with those of shareholders. We argue that overconfidence and optimism, which are likely to characterize managers, provide an alternative solution to this agency problem. Whereas risk-averse rational managers tend to postpone the addition of new projects until precise information is known about them, overconfident and optimistic managers hesitate less before making their decisions. Moderate levels of overconfidence and optimism tend to align these decisions with the interests of shareholders, increase firm value, and reduce the need for option compensation. In fact, compensating overconfident, optimistic managers as if they were rational hurts shareholders by unnecessarily transferring shareholder wealth to managers and by encouraging managers to take risks that are not in shareholders’ best interests. JEL classification codes: G31, L21.