Business leaders need to be confident in their decisions, but having too much confidence can lead them to make poor ones, such as ill-timed investments and ill-fated corporate mergers. So being able to sniff out an overconfident CEO could save investors some pain.
One common, albeit indirect, bellwether of overconfidence is the tendency to hold deep “in-the-money” stock options rather than exercise them and pocket the gain, research suggests.
So-called longholder CEOs—who hold options that are at least 40 percent in the money—tend to have personality traits associated with overconfidence and lesser managerial ability, observe Chicago Booth’s Steve Kaplan and Anastasia A. Zakolyukina and Dartmouth’s Morten Sørensen.
Executive stock options generally offer the right but not the obligation to buy shares at a defined price by a certain date. An option is “in the money” when the current stock price is greater than an option’s exercise price. From that point until the contract’s expiration date, the option can be exercised and converted to cash, allowing the holder to pocket the difference between the market price and the exercise price.
In theory, risk-averse CEOs looking to diversify their portfolios would exercise in-the-money options well before their expiration date, while more confident CEOs might hold their options nearly to expiration, believing the shares will rise further. But confidence isn’t the only reason to hold an in-the-money option; tax considerations, board rules, and other variables come into play.
To confirm a connection between overconfidence and longholding behavior, the researchers analyzed personality assessments of more than 2,600 aspiring CEO candidates, drawn from four-hour interviews performed by ghSMART, a management consulting company, between 2001 and 2012. The assessments rated each candidate on 30 specific personality traits and abilities. Of the 67 candidates who later became CEOs of public companies, 58 were not longholders and nine were longholders, allowing the researchers to compare the personalities of both groups.
Longholders tended to score lower than nonlongholders in a number of areas—from analytical ability and organizational skills to acceptance of feedback and calmness under pressure. Many of those characteristics are typically associated with overconfidence, according to various psychology studies, the researchers note.
Those traits also tend to move in sync and, taken together, paint a useful picture of a CEO’s “general ability,” argue Kaplan, Sørensen, and Zakolyukina. Using a regression analysis, the researchers find that longholding is “significantly negatively related” to overall ability—implying that longholders not only tend to be overconfident, but they also tend to be less talented than nonlongholders. “Combined, then, our findings are consistent with overconfidence being associated with lower general ability,” they write.
The researchers also fleshed out the connection between overconfidence and managerial talent by looking at patterns in earnings forecasts. Using a sample of 31 CEOs of public companies who provided a total of 216 quarterly forecasts, they find that rosier predictions (relative to actual earnings figures) were correlated with lower ability, further suggesting overconfident CEOs are less talented than those who aren’t.
Finally, the researchers studied the link between short-term operating performance and corporate investment decisions. Longholder CEOs are more likely to boost capital expenditures when cash flows are strong and pull back harder when they’re weak, Kaplan, Sørensen, and Zakolyukina suggest.
“We confirm that investments by firms with longholder CEOs are significantly more sensitive to cashflows,” the researchers write. “Moreover, we find investments by firms with less talented CEOs are also significantly more sensitive to cash flows.”