This view challenges the two traditional explanations for investment distortions - the misalignment of managerial and shareholders' interests and asymmetric information between corporate insiders and the capital market. Both cause investment to be sensitive to the amount of cash in the firm.
Under the former view, managers over-invest to reap private benefits, such as 'perks' and large empires. Because 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 the latter approach, the managers, acting in the interest of shareholders, restrict external financing in order to avoid diluting the undervalued shares of their company. Cash flow increases investment, but reduces the distortion.
One explanation for 'investment-cash flow sensitivity and suboptimal investment behaviour' stems from looking at the personal characteristics of the top decision-maker within the firm, namely the boss, rather than at firm-level characteristics.
Analysis of a sample of 477 large publicly traded US companies from 1980 to 1994, reveals that one important link between investment levels and cash flow is the tension between the beliefs of the chief executive and the market about the value of the firm.
They add that this overconfidence story builds upon a familiar concept in social psychology, known as the 'better-than-average' effect. This means that when individuals assess their relative skill they tend to overstate their acumen relative to the average. As well as affecting decisions, it affects causality. Because individuals expect their behaviour to produce success they are more likely to attribute good outcomes to their actions, but bad outcomes to (bad) luck.
The overconfidence argument has other policy implications. The traditional theories on investment distortions, based on capital market imperfections or misaligned incentives, propose timely disclosure of corporate accounts or high-powered incentives as potential remedies.
However, these provisions might not be enough. A manager whose incentives are perfectly aligned and who does not face any informational asymmetries may still invest sub-optimally if he is overconfident. He believes that he is acting in the best interests of shareholders.
Thus, refined corporate governance structures, involving a more active board of directors or constraints on the use of internal funds, may be necessary to achieve ideal investment levels.
Source: CEO overconfidence and corporate investment
Ulrike Malmendier, Stanford University, Geoffrey A Tate, University of Pennsylvania, and Jun Yan, Stanford University
The Journal of Finance, Vol LX No 6, December 2005
Review by Roger Trapp