Title: The Bright Side of Managerial Over-Optimism (free)
Authors: Gilles Hilary (INSEAD), Charles Hsu (Hong Kong University of Science and Technology), and Benjamin Segal (INSEAD)
Publisher: Social Science Research Network; INSEAD Working Paper No. 2013/82/AC
Date Published: June 2013
Does having an executive suite with a very positive outlook affect a company’s fortunes? Overconfidence, in the form of managerial cockiness that typically underestimates risk, has long been derided, with many analysts arguing that an executive’s hubris can lead to dangerous or selfish decisions that reduce shareholder value. But this paper, one of the first to empirically examine the related but different state of over-optimism, finds that when executives become really upbeat about earnings because of a string of recent successes, they appear to work harder to meet their bullish predictions, leading to an even more improved firm performance. In fact, the authors say, goals that might have seemed beyond reach when announced not only turn out to be achievable but are often exceeded, so long as a manager’s zeal is tempered by a continued respect for risk. Put another way, these rationally exuberant managers are able to turn their optimism into reality.
The authors combined several databases on major North American companies, compiling information on their quarterly prediction announcements, earnings reports, executive characteristics, and stock returns from 1998 through 2008. They controlled for a range of factors, including firm size, book-to-market value, industry trends, managers’ experience, the company’s ownership model, and the number of independent board members.
The authors weighed the managerial forecasts of quarterly earnings against both contemporaneous analyst predictions and the company’s subsequent performance. In their main analysis, the authors defined a success as a scenario in which a chief executive announced quarterly earnings that beat the company’s publicly stated predictions. The authors also conducted six analyses with slightly different definitions of success, such as improvement in quarterly performance. The results were consistent throughout.
After calculating the number of consecutive successes that CEOs oversaw in the four quarters preceding a particular forecast, the authors found a cycle of good feeling. The stronger a firm’s recent performance, the more that managers’ forecasts were imbued with a sense of optimism. The authors’ textual analysis of the language in company press releases also revealed a more upbeat tone in the wake of strong performances. By showing that the belief in future success has a dynamic ebb and flow, the results suggest that “managers are made (not born) over-optimistic,” the authors write.
Crucially, these sanguine managers put their money where their mouth is. The authors found that managers appear to make a greater effort to meet their forecasts when they seem overly upbeat. In other words, by stating a goal for the company’s earnings that is beyond what the consensus of analyst forecasts indicate it should be, managers must work harder to close the gap and meet or beat their prediction.
Specifically, the authors found that firm performance, as measured by return on assets, increased the more the firm met or exceeded managers’ expectations during the previous four quarters. Quarterly stock returns also increased as the number of prior successes went up. What’s more, firms’ returns on assets through the next year were also positively affected, suggesting that the bounce from over-optimism persists at least over the short and medium terms.
The results were consistent when calculated in different ways, such as applying the same analysis to firms’ CFOs instead of CEOs. The findings also held true if recent successes were calculated over three, five, or six quarters instead of four, and if a firm’s hot streak was measured as the total number of successes over the previous four forecasts instead of the number of consecutive positive outcomes.
The authors found that managers who have a longer streak of meeting or beating their goals were more likely to do the same in the subsequent quarter than those with a shorter run of recent successes. And some managers do consistently display a greater ability to deliver on their promises than others.
Finally, the authors note that their findings can’t be explained away by misbehavior, such as deceptive managerial practices. Unlike earnings reports, the authors’ measures of accounting manipulation or abnormal cash flows showed no relationship to the number of past forecast successes.
“These results suggest that the increase in firm performance is genuine,” the authors write, “and that managers, being over-optimistic regarding the likelihood of meeting the expectations they set, may not feel the need to manage earnings to reach their forecasts.”
Overconfidence can be dangerous, but this study finds that top executives whose firms have a recent history of beating their earnings forecasts become more optimistic about their appraisals. And the cheery outlook pays off in increased firm performance, as executives appear to work harder to meet those optimistic goals.
- Matt Palmquist is a freelance journalist based in Oakland, Calif.