Overconfidence, Investment Policy, And Manager Welfare

Risk-averse managers sometimes choose to stay away from risky projects that would increase firm value. Overconfident managers overestimate their personal ability to reduce risk, and as a result may make capital budgeting decisions that are in the better interest of shareholders. Interestingly, this benefit to the firm does not necessarily result in diminished welfare for the manager. First, when compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that provide him with better insurance. Second, since overconfident managers overvalue the product of their information acquisition efforts, their bias naturally commits them to exert effort.