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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