The Bright Side of Managerial Over-Optimism

HILARY, Gilles | HSU, Charles | SEGAL, Benjamin | WANG, Rencheng

Most people tend to be over-confident and over-optimistic – they have too great a belief in their own abilities to influence outcomes and believe the outcomes will be positive. Usually, these biases have been associated with sub-optimal decisions. But new research suggests they also have an upside.

Over-optimism, boosted by over-confidence, can lead managers to put in greater effort and in the process improve firm profitability and market value, according to the study by Gilles Hilary, Charles Hsu, Benjamin Segal and Rencheng Wang.

They showed that over-optimism in managers can be boosted over time after they experience a series of successes, and this may encourage them to exert greater effort because they expect it will pay off.

“Naturally, this additional effort can have a positive effect on firm performance, which increases following a series of successes even if the increase remains below the level expected of the over-optimistic manager,” they said.

They demonstrated this effect using 9,163 management forecasts from 1998-2010 to compare management earnings forecasts with analyst consensus as a measure of over-optimism. They also measured over-optimism based on the content of press releases and CEOs’ option holdings (specifically, whether CEOs were holding onto their stock options when the stock price was more than 67 per cent above the exercise price). They measured the streak of successes in the previous year using the number of quarters in which earnings realisation equal to or above the manager’s expectation.

The results showed that managerial over-optimism flowed from past successes. This effect was stronger when managers had greater flexibility in decision-making and have less experience. The effect was weaker when there is less disagreement among market participants with respect to the success of different actions.

Their results further showed that managerial over-optimism was associated with improved firm performance. The authors also demonstrated the extent of managerial effort by looking at when managers took actions that deviated from their personal goals but benefited the company. These included fewer personal trips, involvement in time-consuming managerial actions represented by seasoned equity offerings, and comments on earnings conference calls which indicated a higher level of engagement. Such efforts correlated with better firm performance.

“We were able to systematically integrate a series of links that go from past performance to over-confidence, from over-confidence to over-optimism, from over-optimism to effort, and from effort to performance,” they said.

Importantly, the latter was genuine, not manipulated.

“Firm accounting performance and quarterly market returns increased with increases in managerial over-optimism, but measures of the accruals and real earnings management were not affected. This suggests that managers who were over-optimistic about the likelihood of meeting their expectations did not feel the need to manage earnings in order to reach their forecasts,” they said.

HSU, Charles