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Sunday, 6 June 2010

Overconfidence leads to innovation

Economists Alberto Galasso and Timothy S. Simcoe explore the relationship between CEO's overconfidence and the level of innovation (measured by patenting) of the company they lead. They hypothesize that overconfident CEOs, who underestimate the probability of failure, are more likely to pursue innovation, and that this effect is larger in more competitive industries. They test these predictions on a panel of large publicly traded firms for the years 1980 to 1994:

We find a robust positive association between overconfidence and citation-weighted patent counts in both cross-sectional and fixed-effect models. This effect is larger in more competitive industries. Our results suggest that overconfident CEOs are more likely to take their firms in a new technological direction.
"Overconfidence" is measured by using CEOs' personal investments to capture "revealed beliefs" about their firms' future performance. Specifically, CEOs are classified as overconfident if they hold highly in-the-money stock options [the market price of the underlying stock is much higher than the option price] after they are fully vested [the options can be exercised; in other words, the CEO's are not exercising profitable options - presumably in the hope of making even more in the future]. The main result is that the arrival of an overconfident CEO is correlated with a 25 to 35 % increase in citation-weighted patent counts (i.e. citations received by patents filed in a given year).

The findings may help explain why snotty CEOs remain commonplace in spite of the tendency for these executives to destroy value through unprofitable mergers and sub-optimal investment behaviour.

Galasso, Simcoe, CEO Overconfidence and Innovation; ungated version.

The image shows a work by the Belgian artist Thomas Lerooy, known for his big-headed sculptures.

4 comments:

Anonymous said...

I don't buy this and moreover the logic seems faulty. In some ways this is similar to stock analysis fallacy in that you only analyse the survivors. I did read what was available, perhaps someone who paid for the article could enlighten the rest of us if the authors also analysed the smoking wreck type of overconfident ex-CEOs.

I have had the misfortune to experience overconfident leaders but as the companies imploded I do not believe these ever made it into this glorious statistics.

Then you have the charismatic type like Steve Jobs that surround themselves with an unreality field that makes people truly beieve that the insane schedule is actually going to work. I have been there too. Sure, you can launch the iPods, the iPads and more but you end up with trenches full of burned out people. While I did experience my share of "death march" projects I thankfully avoided the burnout though many of my colleagues were not so lucky.

Anonymous said...

Mark,

I need to look at the entire article, but based on your report:

1. The studied period was 1980-1994--Why not 1850-1900? Why not 1600?

2. Publicly traded companies--Why limited only to public traded? is it because of the availability of information, or otherwise?

Mark Schweizer said...

@anon 8:35:00:

Yes, I guess the answer to both your questions is: because the data was available. Here is what they say on the data set:

"We begin with a panel of 450 large publicly traded U.S. firms between 1980 and 1994. These
data are described in Hall and Liebman (1998) and Yermack (1995). Each firm in the sample
appeared at least four times on a Forbes magazine list of the largest U.S. companies. These
data provide a very detailed picture of CEO's stock option holdings, which Malmendier and
Tate (2008) use to construct the measure of CEO overconfidence described below."

In other words: they could rely on an earlier paper on CEO overcofidence which they then could correlate to patenting. Constructing their own measure of CEO overconfidence would have been very, very time consuming.

TJ said...

Surely "over-confidence" requires that the CEOs' beliefs about the future worth of their companies is misplace (i.e. the share price doesn't rise as fast as their position requires). The definition set out here seems rather to be a measure of "confidence", which could potentially be well-founded. It also ignores the fact that CEOs may be eager to retain shares and options so as not to spook employees or the market.

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