As a stockholder, would you prefer a CEO who is strictly rational about her firm’s future prospects, or a CEO who is somewhat overoptimistic? Researchers at Texas A&M University show theoretically that for risk-averse CEOs, being somewhat overoptimistic is a good thing for shareholders.
Most CEOs are undiversified, meaning that a large fraction of their personal wealth is in invested their company. Stockholders, on the other hand, are typically well diversified, with investments across numerous companies. These differences mean that a risk-averse CEO who is strictly rational will turn down some risky investment projects that the stockholders would like the firm to make. If this happens, the result is lower firm value.
“We show theoretically that overoptimism can help offset the effect of the CEO’s risk aversion,” Texas A&M finance professor Shane Johnson says. “The result is that a CEO who is moderately overoptimistic will invest the way shareholders would want her to investâ€”this maximizes firm value.” In contrast, a purely rational CEO turns down too many investment projects relative to the optimal level, whereas a CEO who is too overoptimistic accepts too many investment projects. Both underinvestment and overinvestment produce firm values below what it could be.
“If the theory is correct, CEOs who are somewhat overoptimistic should face a lower probability of termination than rational CEOs or too-overoptimistic CEOs face. A board doesn’t necessarily know a CEO’s level of optimism when it hires her. It learns by watching his decisions over time,” Johnson says. If CEOs who are somewhat overoptimistic maximize firm value, they should be more likely to keep their jobs than would CEOs with too-low or too-high optimism. Using a large sample of CEO terminations, the team finds strong empirical support for the theoretical predictions. The results are consistent with the view that CEOs who are somewhat overoptimistic maximize firm value.
Before this research was conducted, the common belief was that any level of over-optimism was bad, says Johnson. “Our paper is one of a series that argues that some level of over-optimism is good for CEOs,” he says. “Given a choice between a very rational CEO and a moderately overoptimistic one, the somewhat overoptimistic one is the better choice.”
The research was conducted by Texas A&M finance professor Shane Johnson; doctoral students T. Colin Campbell, Jessica Rutherford and Brooke Stanley; and former Texas A&M professor Michael Gallmeyer, who is at the University of Virginia.
For more information, contact Johnson at firstname.lastname@example.org.
“CEO Optimism and Forced Turnover” by T. Colin Campbell, Michael Gallmeyer, Shane A. Johnson, Jessica Rutherford and Brooke W. Stanley was published in Journal of Financial Economics.
Categories: Research Notes