Accounting and various aspects of finance
Mehdi Nikravesh
Abstract
This study examines the effect of firms’ chief executive officers’ overconfidence on their firms’ profitability and the predictability of this profitability. The study tests hypotheses regarding the significant positive impact of chief executive officers' overconfidence on profitability ...
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This study examines the effect of firms’ chief executive officers’ overconfidence on their firms’ profitability and the predictability of this profitability. The study tests hypotheses regarding the significant positive impact of chief executive officers' overconfidence on profitability and its predictability. This is accomplished using the Generalized Method of Moments regression analyses on data from 257 CEOs of firms listed on the Tehran Securities Exchange over a sixteen-year period. The initial results indicate positive impacts of overconfidence on firms’ profitability and the predictability of future profitability. The robustness of the findings was tested by altering the profitability measures from return on assets (ROA) and return on equity (ROE) to Tobin's Q, as well as by changing the proxy for managerial overconfidence. These checks emphasize the role of overconfidence in the examined context. These findings support the positive roles of employing overconfident managers in the firms. By contributing to the limited body of literature on the positive effects of managers’ overconfidence, the findings can be used by investors, analysts, and other users of the results to consider overconfidence in their analyses of profitability and its predictability.Keywords: Managerial Overconfidence, Profitability, Predictability Of Future Profitability, Behavioral Approach IntroductionManagerial overconfidence, the individual tendency to be optimistic about the firm’s future and their power over it (Skala, 2008; Hribar and Yang, 2016), is one of the most significant biases studied in finance and accounting literature. Prior research has shown the negative role of this behavioral bias on firms’ finance and financial reporting features such as dividend payment (Deshmukh et al., 2013; Mashayekh & Behzadpur, 2014), finance policies (Malmendier & Tate, 2005; Malmendier & Tate, 2008), financial restatement (Presley & Abbott, 2013; Shekarkhah et al., 2019), and management earnings forecasts (Mehrani & Taheri, 2015; Hribar and Yang, 2016; Sheri Anaghiz et al., 2019). While numerous studies have focused on the negative impact of managerial overconfidence, there are relatively few that have explored the positive aspect of the bias. One of the positive impacts of overconfidence may include the improvement of firms’ profitability and its predictability (Kim et al., 2022).Because of their optimistic viewpoint regarding future firm performance, overconfident managers often invest in R&D and creative activities, potentially resulting in higher profits for their firms (Galasso & Simcoe, 2011; Hirshleifer et al., 2012; Xia et al., 2023). These activities may have long-term outcomes, including profitability. Consequently, the performance of firms managed by overconfident chief executive officers tends to be more positive compared to other firms. Moreover, due to the long-term investments made by overconfident CEOs, the future profitability of their firms is often higher compared to those managed by not-overconfident managers. Therefore, the predictability of future performance tends to be higher in firms that have overconfident managers (Kim et al., 2022). These theoretical predictions require empirical testing, and this paper conducts such an examination in an emerging market context, specifically the Tehran Securities Exchange.Several important reasons exist for studying the effects of firms' chief executive officers' overconfidence on their firms' profitability and the predictability of this profitability. First, this study heightens the understanding of economic decision-makers regarding the potential impacts of overconfidence, which is useful for perceiving its economic outcomes in firms. Second, it can reveal the role of bias in an emerging market. Third, this research employs dynamic panel data analyses to test the hypotheses, as some prior studies have shown a serial correlation between dependent variables, including profitability and predictability (McNamara & Duncan, 1995; Mashayekhi & Mennati, 2012; Kim et al., 2022), which has been overlooked in previous research concerning the role of overconfidence in profitability and its predictability. Fourth, as suggested by Kim et al (2022), there is less evidence about the positive impacts of overconfidence compared to its negative effects. This paper contributes to the literature by presenting evidence about the positive role of managerial overconfidence. Literature ReviewOverconfident managers usually possess a positive outlook on their abilities and they tend to forecast the future optimistically (Heaton, 2002; Hribar and Yang, 2016). This viewpoint often leads to overinvestment, especially in R&D and creative activities (Galasso & Simcoe, 2011; Hirshleifer et al., 2012). Therefore, there is a higher probability of achieving greater profitability in firms managed by overconfident managers. Based on this, the first hypothesis is developed as follows.H1: Managerial overconfidence has a significant positive impact on firms’ profitability.Overinvestment in firms led by overconfident CEOs is often long-term. By creating competitive advantages through these investments, these firms can experience continuous profits (Kim et al., 2022). Therefore, these profits can be more predictable than the profits of firms managed by non-overconfident managers. This expectation can be formulated into a hypothesis as follows.H2: Managerial overconfidence has a significant positive impact on the predictability of firms’ profitability. MethodologyThe study’s hypotheses were tested using Generalized Method of Moments regression analyses on data from 257 CEOs of firms listed on the Tehran Securities Exchange over a sixteen-year period (2007-2022). Initial analyses were conducted using the study’s main proxy for managerial overconfidence, as introduced by Sheri anaghiz et al. (2019). Return on Assets (ROA) and Return on Equity(ROE) are two main proxies for measuring profitability. Additional analyses, as the robustness checks, examined the hypotheses by changing the measure of overconfidence to overinvestment proxy introduced by Schrand & Zechman (2012) and changing the measures of profitability to Tobin’s Q. To assess predictability, I used the correlation between present and future profitability changes. I tested the hypotheses using two regression models that included control variable such as financial leverage, firm size, sales growth, earnings growth, growth opportunities, earnings volatility, discretionary accruals, and lagged dependent variables. ResultsThe primary results indicated positive impacts of overconfidence, as measured by the main proxy, on firms’ profitability and predictability of future profitability, as indicated by proxies such as Return on Assets and Return on Equity. The robustness checks, which involved changing the profitability measures from these proxies to Tobin’s Q, showed the significant effects of managerial overconfidence on profitability and its predictability. Further robustness checks, which involved changing the managerial overconfidence proxy to an overinvestment proxy, emphasized the role of overconfidence in the examined context. Overall, the findings support the hypotheses of the research. DiscussionThe results showed the significant role of CEOs’ overconfidence in generating profits and improving their predictability. These findings highlight the importance of the behavioral approach in explaining the positive effects of CEOs’ cognitive bias on organizational performance. These findings are consistent with previous studies by Hirshleifer et al. (2012), Zavertiaeva et al. (2018), Alberts (2018), and Kim et al. (2022), which also support the idea that employing overconfident CEOs can benefit firms. ConclusionThis paper highlights the significance of managerial overconfidence in shaping firms’ profitability and its predictability. The findings shed light on one of the most important reasons why overconfident managers are hired in firms and how their presence can impact the predictability of financial performance. These results can be valuable for investors when making decisions about firms and for analysts when analyzing both present and future financial performance. The main limitation of the paper is that the sample did not include the financial firms such as banks, insurance companies, and investment firms.AcknowledgmentsI thank my family for their continued support. Managerial overconfidence, the individual tendency to be optimistic about the firm’s future and their power over it (Skala, 2008; Hribar and Yang, 2016), is one of the most significant biases studied in finance and accounting literature. Prior research has shown the negative role of this behavioral bias on firms’ finance and financial reporting features such as dividend payment (Deshmukh et al., 2013; Mashayekh & Behzadpur, 2014), finance policies (Malmendier & Tate, 2005; Malmendier & Tate, 2008), financial restatement (Presley & Abbott, 2013; Shekarkhah et al., 2019), and management earnings forecasts (Mehrani & Taheri, 2015; Hribar and Yang, 2016; Sheri Anaghiz et al., 2019). While numerous studies have focused on the negative impact of managerial overconfidence, there are relatively few that have explored the positive aspect of the bias. One of the positive impacts of overconfidence may include the improvement of firms’ profitability and its predictability (Kim et al., 2022).
