They Pursue Development of New Products with Less Fear of Failure

Newswise — While an overconfident CEO is often portrayed as a liability, making harmful business decisions based on arrogance—and ultimately running a company into the ground—a study in the latest Journal of Finance suggests that overconfident CEOs in fact help companies achieve greater levels of innovation by pursuing riskier projects with potentially greater rewards, and typically fostering larger investments in research and development.

David Hirshleifer at the University of California, Irvine’s Paul Merage School of Business and his coauthors studied the effects of overconfident CEOs—leaders who often manage companies through the sheer force of ego and arrogance—by looking at corporate investments in innovation and at the number of patent applications and patent citations filed in the decade between 1993 and 2003. He and his team discovered that overconfident CEOs are more likely to achieve innovative success for research and development, and to advance successful patents.

High risk, innovation and overconfident management make a fascinating equation, according to Professor Hirshleifer. “An overconfident CEO underestimates the possibility that he or she might be wrong. But the overconfident CEO might be extremely talented,” he says. “Albert Einstein was very grudging in accepting quantum theory despite compelling evidence, but no one would deny that he was talented.” A famous example of an overconfident CEO is Steve Jobs, whose leadership style is discussed in Hirshleifer’s paper.

The bottom line, according to the researchers: An overconfident CEO achieves greater innovation than non-overconfident managers in innovative industries because the manager will be likely to dive into the development of new products with less fear of failure. A copy of the article can be found here:

Professor Hirshleifer’s co-authors are Angie Low, from the Nanyang School of Business, Nanyang Technological University, and Siew Hong Teoh, from The Paul Merage School of Business. Hirshleifer offers a few insights on his research:

Q. Why would a firm hire an overconfident manager?A. Maybe by mistake, or because an overconfident manager may sometimes also be very talented. Our evidence suggests an additional reason: because overconfident managers are, on average, better innovators. They invest more in R&D, obtain a greater number of patents, these patents are cited more often by other patents. Furthermore, we find evidence that overconfident managers are more effective in converting growth opportunities into value.

Q. How is increasing investment in risky projects beneficial to shareholders?A. It could be good or bad. Sometimes the best projects are also very risky. Managers who have a bureaucratic mentality of protecting themselves against blame are going to tend to avoid big risks, and will miss out on the big payoffs from success. In some businesses that may be all right, but in industries where innovation is crucial, this may not be the best for shareholders. In general, if managers are risk averse, shareholders can motivate them to take more risk using option compensation to expand the upside for the manager. But another approach is to hire a manager who is overconfident, and therefore takes risks more readily.

Q. How do you define an innovative industry? A. In our study, an innovative industry is one where there are many patents. Pharmaceuticals and high-tech companies are examples.

Q. There is evidence that overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value. Why is that and why only in innovative industries?A. Our surmise is that overconfident CEOs are more ready to take on risky projects that are very promising, but could also easily fail. Less confident CEOs may shy away from such projects, missing out on such growth opportunities. Innovative industries tend to have more high risk growth opportunities, and more scope for CEOs to be overconfident about them.

Q. Clearly there is a positive side to CEO overconfidence. What’s the downside? A. A manager who is too detached from reality may plunge his firm into doom through impetuosity or stubbornness. Back in the late 1980s, while running a company called NeXT Inc., Steve Jobs refused to include a floppy drive in a computer the company developed. While extremely innovative for its time, the NeXT Computer was not commercially successful. This illustrates how overconfidence, and being too far ahead of your customer, can prevent success.

David A. Hirshleifer is a professor of finance and Chair of Business Growth at the Merage School. His expertise includes corporate finance, investments, and behavioral finance. Some of his recent research has been on psychology in firms and markets, social transmission of investment ideas and behavior, and the effect of emotions on stock prices. He has also conducted research on risk management, determinants of futures prices, social interactions and markets, fads and fashions in economic decisions, and how psychological bias affects political and regulatory decisions. His faculty Web page: