Darryl Laws

 Overconfidence. Overconfident decisions often indicate a loss of contact with reality and an overestimation of one’s own competence or capabilities, especially when the person exhibiting it is in a position of power. Doukas and Petmezas (2007) argue that managerial overconfidence results from a self-attribution bias. Specifically, overconfident CEOs feel that they have superior decision-making abilities and are more capable than their peers. The presence of these cognitive biases encourages CEOs to emphasize their own judgment in decision making and to engage in highly complex transactions such as diversifying acquisitions that are not necessarily homogenous with exiting assets of their company. Because of their overconfidence, these CEOs tend to underestimate the risks associated with a merger or overestimate the possible synergy gains from a business combination. 

The analysis of overconfidence relates several branches of behavioral economics and psychology literature. First, extensive amount of experimental literature documents the tendency of individuals to consider themselves above average on positive characteristics (Alicke, 1995; Alicke, 1985; Svenson, 1981). Example, Svenson demonstrates that the vast majority of subjects rate their driving skills as above average. Svenson’s finding has been replicated numerous times in various countries and with respect to various IQ or skill related outcomes like driving. When asking a sample of entrepreneurs about their chances of success, Cooper (1988) found that 81% answered between 0 and 30% (with 33% attaching exactly zero probability to failure). However, when asked the odds of any business like theirs failing, only 39% of them answered between 0 and 30%. Larwood and Whittaker (1977) find that corporate executives are particularly prone to this form of self-serving bias. The better than average effect also affects the attribution of causality. Because individuals expect their behavior to produce success, they attribute outcomes to their actions when they succeed and to bad luck when they fail (Miller and Ross, 1975; Feather and Simon, 1971). This self-serving attribution of outcomes reinforces overconfidence. Miller and Ross (1975) found; 1) that overconfident CEOs are more likely to pursue acquisitions when their firms have abundant internal resources, 2) overconfident CEOs are significantly more likely than other CEOs to undertake a diversifying merger and 3) overconfident CEOs were observed to use cash on the balance sheet to finance their mergers more often than other CEOs who leverage their company’s stock value as if it were a check book.


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Darryl Laws

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