Confidence is in short supply these days. The prospect of a lengthy recession has left just about everyone feeling nervous and insecure. Finance chiefs in particular are gloomier than ever, as indicated by CFO magazine’s recent Business Outlook surveys, which found that nearly 90 percent don’t anticipate a return to normal growth conditions until late 2009.
Yet, in spite of justified anxieties about the economy, CFOs generally remain an optimistic bunch. In fact, the typical CFO is too confident, according to Itzhak Ben-David of the University of Chicago Graduate School of Business.
The corporate Dr. No is really Dr. Yes in disguise? It’s hard to imagine. Yet, in a new paper, Ben-David, along with John Graham and Campbell Harvey, professors at Duke University’s Fuqua School of Business, suggest that, on average, CFOs are overconfident. Overconfident finance chiefs tend to use lower discount rates when valuing cash flows and assign higher values to projects. Their companies invest more, use more debt, and are less likely to pay dividends. Multitasking is a hallmark, too, as overconfident CFOs tend to take on many projects at once.
How do you locate the boundary between confidence — a necessary quality in every manager — and overconfidence? Ben-David and his colleagues did so by measuring bets on the stock market. The authors surveyed 7,000 CFOs over a six-year span, asking them to predict a range of 1- and 10-year returns of the S&P 500 index and divulge how certain they felt about their predictions. Although most of the CFOs felt very sure of themselves when selecting, they were correct just 38 percent of the time. The level of certainty that a CFO felt about his stock pick, and the frequency of his misjudgments, correlated to his level of confidence.
To overconfident CFOs, risky projects seem safer than they really are. “Overconfident managers underestimate risk and therefore take actions with excessive risk,” write the professors. Of course, managers who take risks that succeed are rewarded, rising in the corporate hierarchy. “It’s easier to climb the organizational ladder if you’re confident,” says Ben-David, who will join the Ohio State University Fisher College of Business in June.
Brimming with self-assurance, cocky CFOs often underestimate competitors and the wisdom of the market, says Ben-David. When making financing choices, they might incorrectly price the firm’s securities, as they assume the market is undervaluing the company’s worth. (This assumption also explains their penchant for repurchases.) Overconfidence can wreak havoc on mergers, too, as faith in synergies overshadows real obstacles. “When overconfident CFOs announce mergers, they usually have a negative market announcement return,” Ben-David says.
Can a CFO’s overconfidence lead to mischief? It’s a slippery slope, according to Catherine Schrand and Sarah Zechman, of the University of Pennsylvania’s Wharton School of Business. In a new working paper, Schrand and Zechman define overconfidence as having “unrealistic positive beliefs” about an uncertain outcome. This bias, they say, is often revealed in financial reports where earnings have been managed. When that happens, outright fraud may be right behind.