Overconfidence leads to innovation

Economists Alberto Galasso and Timothy S. Simcoe explore the relationship between CEO's overconfidence and the level of innovation (measured by patenting) of the company they lead. They hypothesize that overconfident CEOs, who underestimate the probability of failure, are more likely to pursue innovation, and that this effect is larger in more competitive industries. They test these predictions on a panel of large publicly traded firms for the years 1980 to 1994:

We find a robust positive association between overconfidence and citation-weighted patent counts in both cross-sectional and fixed-effect models. This effect is larger in more competitive industries. Our results suggest that overconfident CEOs are more likely to take their firms in a new technological direction.

"Overconfidence" is measured by using CEOs' personal investments to capture "revealed beliefs" about their firms' future performance. Specifically, CEOs are classified as overconfident if they hold highly in-the-money stock options [the market price of the underlying stock is much higher than the option price] after they are fully vested [the options can be exercised; in other words, the CEO's are not exercising profitable options - presumably in the hope of making even more in the future]. The main result is that the arrival of an overconfident CEO is correlated with a 25 to 35 % increase in citation-weighted patent counts (i.e. citations received by patents filed in a given year).

The findings may help explain why snotty CEOs remain commonplace in spite of the tendency for these executives to destroy value through unprofitable mergers and sub-optimal investment behaviour.

Galasso, Simcoe, CEO Overconfidence and Innovation; ungated version.

The image shows a work by the Belgian artist Thomas Lerooy, known for his big-headed sculptures.