Choosing a new CEO – does overconfidence pay off?

Chief executives are famous for being overconfident – being a leader and a visionary means a certain sense of optimism, confidence in one’s own abilities, and faith in the company they run. 

The question asked in this study is: is overconfidence sought out in CEOs? And are overconfident CEOs better for the company’s bottom line?

Overconfidence always has its pitfalls, and in companies, can be really damaging – overestimations of returns, projects, products and staff, and underestimations on the probability of failure can cause a loss of value in a company. Conversely, overconfident CEOs are often more likely to innovate and take risks that pay off.

Overconfidence and corporate leadership

There does seem to be a link between overconfidence and corporate leadership, and the researchers have examined the link to see whether when CEOs are being selected, overconfidence plays a role in their selection, and is not something that develops after they are in the top job.

Potential candidates were analysed at the selection stage, with evidence being clear – overconfident CEOs are preferred. This is examined by the board using the evidence they have available – the traits, actions and characteristics of overconfidence, which were used in the study.

The researchers say, ‘The overall picture that emerges is that overconfident CEOs are not necessarily good or bad for shareholders: in certain contexts, when a mature, sluggish-growth firm seeks strategic renewal, overconfident CEOs contribute to value creation. In other contexts, however, the selection of overconfident CEO appears to be driven by considerations other than value creation.’

Two hypotheses were proposed and tested regarding why companies prefer overconfident CEOs.

Hypothesis 1

Boards act in the interests of shareholders and choose overconfident CEOs when the company could use someone like that. This choice means that if a company is mature, low-risk and slow-growing, the fresh optimism and risk-taking could create value. A fast-growing and innovative company may also prefer an overconfident CEO to continue growth and innovation. The choice in this circumstance should increase (or keep level) company value.

Previous research has shown that overconfidence encourages growth seeking, with moderate levels achieving better outcomes in both innovation and profit.

Hypothesis 2

This hypothesis uses other factors – an entrenched board has certain preferences, or a board with busy directors may drive this selection. That is, board failure to a certain degree. Board strategy varies and depends on elements like whether the board members are worried about being replaced. Aggressive acquisition strategies that don’t increase shareholder value may be preferred, with overconfident CEOs more likely to follow that route – this is in line with what the other directors want, and are actively seeking to continue with their CEO choice.

If the CEO is a good match for the company needs, there should be a gain due to the appointment, but if there is board failure, it is expected that the value implications are negative, or at least not positive.

The study

The researchers used a sample of 3,188 CEO changes between 1994 and 2011 whereby an internal candidate (with the company for at least a year) was the chosen one. There is a sub-sample of 1,907 CEO turnover events allowing the closer examination of the factors used when choosing a new CEO.

It is true that when a company has overconfident executives, they are more likely to choose an internal hire rather than seeking an external hire. The elements used to determine if a person is overconfident in their position were tenure, current position, and compensation level.

Tests showed that certain types of companies favour overconfident executives as previously explained.  Results show that when averaged out, overconfident executives aren’t much more or less likely to increase value compared with other executives, and there is no great evidence that one’s capabilities as a manager are correlated specifically with overconfidence. Evidence does exist, however, suggesting that overconfident managers can very adequately contribute to strategy changes and offer enhancements in some companies.

Large and lower-risk companies had significant performance improvements after taking on an overconfident executive. These overconfident executives then hired as CEOs are associated with faster growth in assets, PP&E and patents than other, less overconfident executives appointed to the lead role.

The opposite is true when there is board failure – there is no drop or gain in value or performance with an overconfident CEO appointment.

Overconfident CEOs aren’t all they’re cracked up to be – or are they?

Other research has found that overconfident CEOs were related to a loss of value, a propensity for acquisitions, and distort dividend payouts. This is the result of over-optimistic forecasting and financial misreporting. This means overconfident CEOs are also more prone to being fired for poor performance.

Overconfident CEOs push themselves harder to achieve the goals they set for themselves, which is a benefit that often creates value. Overconfident CEOs and acquisitive companies seem to go together, offering some other ideas about these types of individuals and why certain boards may choose them.

Entrenched boards are more likely to take chances on overconfident CEOs because there is less chance of them losing their positions for possibly making poor choices, if the company loses value after the appointment, but additionally, if losses are incurred while implementing innovative strategies, there is room for short-term price fluctuations. Any protections in place for the board (anti-takeover provisions, a classified board) count towards hiring an overconfident CEO.

The outcome of the overconfident CEO

Both hypotheses appear to be true. Performance of the new CEOs confidence is insignificantly associated with subsequent performance of the company. A lot of research previous to this has pointed out that overconfident CEOs are linked with poor performance, but this research hasn’t found such a correlation.

Most other executive characteristics don’t significantly influence the performance of the company after the promotion to CEO, with one exception: longer-tenured executives tend to do better after their appointment, so the longer an individual has been with the company, the better the outcome. This is likely due to greater company knowledge and possibly because the longer a company has held on to a person, the more valuable they may be in terms of contribution.

The actual impacts depend on the company itself, however.

·         Larger, less-risky companies are more likely to promote overconfident executives.

·         Overconfident executives will improve corporate performance after being appointed.

·         Larger, more complex companies, there can be more competition for senior roles and more difficulty separating luck and ability in appointments.

·         Overconfident executives (the ‘lucky’) executives are more likely to take on risks even if they are less able than another candidate. This scenario would theoretically see a reduction (or no improvements) in company value.

·         In large companies, there seems to be a benefit in hiring overconfident CEOs.

·         Confidence is significantly and positively relate to performance in the low risk samples, implying that low-risk companies may benefit from a more confident CEO, who will implement riskier strategies for greater return.

·         There is no significant difference on the impact of an overconfident CEO on entrenched and non-entrenched boards, or between busy and less busy boards.

·         There is not a great deal of evidence pointing to prior acquisitiveness influences an incoming CEO’s confidence on performance.

·         Overconfidence can improve performance if the new appointment is specifically undertaken with a desire to change the company towards greater innovation and risk-taking. If there is no such rationale present, the impact of the incoming CEO is not immediate.

·         Overconfident CEOs are positively associated with patenting, but not research and development.

There are other reasons for overconfidence appointments were explained as possibly tainting the results – family companies, ‘fake it til you make it’ CEOs, older outgoing CEOs and new ‘placeholder’ CEOs, shareholdings in the company ‘proving’ confidence, etc.

So… are overconfident executives more likely to be promoted to CEO, and do they create value?

Boards do favour overconfident internal candidates for the CEO job. Hypothesis 1 and 2 were both supported by the evidence and analysis, and both supported the overconfident CEOs performing at least without doing damage in both scenarios.

Download the full report
Executive Confidence and New CEO Selection
Suman Banerjee, University of Wyoming
Lili Dai, Australian National University
Mark Humphery-Jenner, UNSW
Vikram Nanda, Rutgers University