Theoretical Model on CEO Overconfidence Impact on Corporate Investments

• Published in: The Quarterly review of economics and finance 2021-05, Vol.80, p.545-552
• Main Author: Hatoum, Khalil
• Format: Article
• Language: English
• Subjects: Analysis; CEO overconfidence; Chief executive officers; Corporate investments; Decision making process; Decision-making; Investments; Probabilities
• ISSN: 1062-9769; 1878-4259
• DOI: 10.1016/j.qref.2021.04.005

•CEO overconfidence has destructive effects on corporate investments that is in the form of expected losses or opportunity losses.•Probability of CEO overconfidence helps measure the frequency of overconfidence for CEOs.•A theoretical model can estimate the impact of CEO overconfidence on corporate investment decision making process. This theoretical model estimates the impact of CEO overconfidence on corporate investment decision making process. The model helps us understand how CEO overconfidence impacts corporate investments by quantifying the expected losses and opportunity losses in corporate investments due to CEO overconfidence. This aims to raise organizational awareness about the destructive effects of this bias and ultimately to incentivize organizations to address the personalities of CEO overconfidence. Literature in this area of research supports the existence of destructive effects on corporate investments due to CEO overconfidence. The model focuses on a corporate environment in which a corporate investment can take a positive or negative NPV value. The model also centers on a population composed of both overconfident and non-overconfident CEOs. Non-overconfident CEOs use a Bayesian learning rule to estimate project returns, while overconfident CEOs use a non-Bayesian rule as they tend to commit biases in estimating project returns. A decision tree is then formulated based on the type of corporate investment, level of CEO overconfidence, and corporate investment decision in order to derive the theoretical model.