November 28, 2006
CEO Overconfidence and Executive Compensation
Posted by Lisa Fairfax

Some scholars have recently written about the notion that CEOs tend to be overconfident, and that this overconfidence may lead to bad decision-making because overconfidence leads people to focus on the benefits of a course of action while downplaying the costs and risks.  The literature about overconfidence has a lot of ramifications.  Troy Paredes has an interesting article suggesting that excessive CEO compensation fosters or exacerbates overconfidence because such compensation serves as one (if not the) signal of the CEOs worth and presumably the higher the pay the stronger the signal.   In other words, increased compensation makes CEOs more confident in their abilities and hence more likely to over-estimate the wisdom of their decisions.  In this way, Paredes suggests that corporate governance structures--at least executive compensation structures--may contribute to overconfidence, and thus potentially to ill-advised decisions. 

One could argue that given the current attacks on CEO compensation, such compensation should not foster overconfidence because those attacks undermine the notion that executive pay is tied to an executive's abilities.  Yet those attacks may in fact strenghten the CEO's perception that his pay is tied to merit, and hence increase the CEO's overconfidence.  This is because whenever a CEO's compensation is attacked, a company's instinctive reaction is to defend the compensation, generally in terms of the CEO's positive impact on the Company's performance.

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Comments (2)

1. Posted by Jeff Lipshaw on November 28, 2006 @ 13:23 | Permalink

Interesting. I have known a lot of CEOs. They do tend to be overconfident. But my observation is that it doesn't have anything to do with their compensation. What it has to do with is the fact that the person is the CEO. And "if I am the CEO, then there must be a reason. And the reason is that my [instincts][judgments][experience][fill in the blank] were such that I was hired as the CEO."

Indeed, I would offer the hypothesis (I don't know if it can be tested) that if you set up a corporate hierarchy, there would be more of a correlation between the traits described as "overconfidence" and the person's position in the hierarchy than in the compensation. The problem with CEOs is that gets blurred because the CEO not only is the highest paid, but also sits at the top of the pyramid.


2. Posted by Joshua Wright on November 28, 2006 @ 13:36 | Permalink

Perhaps the most relevant overconfidence bias is that which allows researchers to assert that they can distinguish between "overconfidence" and some other characteristics that correlate with being a CEO.

Also, if higher executive compensation systematically increased the probability of sloppy decision-making resulting in costly errors, I'm fairly confident (and I don't even get paid that much!) that I could imagine a variety of market solutions appropriating the vast number of profit opportunities that would result if this were true...

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