Overconfidence, Compensation Contracts, and Capital Budgeting

The following post comes to us from Simon Gervais of the Finance Department at Duke University, J.B. Heaton of Bartlit Beck Herman Palenchar & Scott LLP, and Terrance Odean, Professor of Finance at the University of California at Berkeley.

In our forthcoming Journal of Finance paper, Overconfidence, Compensation Contracts, and Capital Budgeting, we study the interaction of managerial overconfidence and compensation in the context of a firm’s investment policy. To do so, we develop a capital budgeting problem in which a manager, using his information about the prospects of a risky project, must decide whether his firm should undertake the project or drop it in favor of a safer investment alternative.

Our model shows that a manager’s overconfidence creates two potential sources of value for him and the firm. First, the manager’s overconfidence implicitly commits him to follow an optimal risky investment policy with a flatter compensation schedule. This is valuable when risk-taking incentives come with suboptimal risk-sharing arrangements between firms and risk-averse managers. Second, the manager’s overconfidence commits him to exert effort to gather information that improves the success rate and value of the firm’s investment policy. As we show, the associated benefits can accrue to the firm, the manager, or both, depending on the extent of competition in labor markets and the size of the manager’s bias.

More generally, our model shows that it is the interaction of contractual incentives with the manager’s attributes, including his behavioral biases, that ultimately drives a firm’s decisions. If the manager’s attributes change during his career and if these changes are not accompanied by commensurate adjustments in his compensation contract, the manager’s incentives may eventually diverge from those of shareholders. This in turn makes their firm vulnerable to suboptimal investment policies that reduce its value, such as a series of impulsive acquisitions.

The full paper is available for download here.

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