Counting the cost of overconfident CEOs

In extreme sports and in business, overestimating one’s own ability can be dangerous

Associate Professor Barry Oliver knows only too well the dangers of overconfidence. During the ten years he spent as a competitive paraglider pilot, he saw many of his friends seriously injured or even killed because they overestimated their own ability.

In extreme sports, overconfidence comes at a high price. “We used to call it ‘intermediate syndrome’,” he recalls. “When people have built up their skills to a certain level, they can become overconfident about their ability and do things that are outside their skillset – that’s when they get hurt.”

As a finance researcher, he observed the same type of behaviour in the corporate world – even if the impact was not so immediate or quite so apparent from the outside. He was intrigued by how CEOs could make decisions that were not in the best interests of the company, even though they genuinely thought them to be so due to a misplaced sense of self-belief. He went on to study psychology and is now head of finance at UQ Business School, where his research often links both fields.

“It wouldn’t surprise me if a lot of bad decisions were driven by overconfidence,” says Associate Professor Oliver. If a number of overconfident individuals get together, they can push each other along, believing in a system without any supporting evidence, until someone suddenly realises that it is far out of touch with reality. The GFC, for example was driven by exuberance and excitement as the markets kept rising.”

A range of studies have shown that overconfidence in CEOs is linked to increased risk of failure and distress. Overconfident CEOs increase the chance of a class action by around 25%, and pay too much for other businesses they acquire. They take greater risks and insure less than their less confident peers.

In research from his team, Associate Professor Oliver has found that overconfident CEOs have more short-term debt, even though it brings a liquidity risk to the company. One study shows that they also invest less in corporate social responsibility.

The project looked at 2,138 firms with 3,478 different CEOs from US listed firms across all industry sectors, and took account of the CEO’s share options - where the CEO fails to exercise these options, it suggests they are overconfident about their company.

The research showed that the more confident the CEO, the less their firm invests in activity that has a positive impact on society – such as community involvement, support for charities, corporate governance, workforce diversity, employee relations, the environment and human rights.

“Corporate social responsibility is like an insurance policy – the market is more lenient if the firm suffers some setback,” Associate Professor Oliver explains. “Socially responsible firms suffer less damage to the company’s value in cases where there’s a product recall due to a defect. We argue that overconfident managers do not correctly recognise these risks and invest less in socially responsible behaviour than their less confident peers.”

The research found that female CEOs were significantly less overconfident than male CEOs, although the same rule applied, in that the more overconfident they were, the less they invested in corporate social responsibility.

However having an overconfident CEO is not always a bad thing – previous research has found that they are better innovators. Indeed, in some cases, someone who can pursue a ‘high risk, high reward’ strategy may be exactly what shareholders want.

Associate Professor Oliver says shareholders need to understand the issues to be able to choose the right person for the role. “Shareholders need to be aware of the benefits and the risks associated with overconfidence. If you want to invest in a more socially responsible firm, you should select a CEO who isn’t overconfident. The challenge then is balancing that with a lack drive or direction in innovation and other positive risk-related activities that can result in growth.

“It’s a trade-off that shareholders may struggle with. One solution may be to use employment contracts with CEOs to specify the level of social responsibility you want to see happening in the firm. In this way, shareholders may be able to harness the positive attributes of an overconfident CEO while maintaining a socially responsible focus.”

Last updated:
27 February 2019