We explore behavioral explanations for sub-optimal corporate investment decisions. Focusing on the sensitivity of investment to cash flow, we argue that personal characteristics of chief executive officers, in particular overconfidence, can account for this widespread and persistent investment distortion. Overconfident CEOs overestimate the quality of their investment projects and view external finance as unduly costly. As a result, they invest more when they have internal funds at their disposal. We test the overconfidence hypothesis, using data on personal portfolio and corporate investment decisions of CEOs in Forbes 500 companies. We classify CEOs as overconfident if they repeatedly fail to exercise options that are highly in the money, or if they habitually acquire stock of their own company. The main result is that investment is significantly more responsive to cash flow if the CEO displays overconfidence. In addition, we identify personal characteristics other than overconfidence (education, employment background, cohort, military service, and status in the company) that strongly affect the correlation between investment and cash flow. We are indebted to Brian Hall and David Yermack for providing us with the data. We are very grateful to Jeremy Stein for his invaluable support and comments. We also would like to thank Philippe Aghion, George

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing. The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

Compensation, status, and press coverage of managers in the U.S. follow a highly skewed distribution: a small number of ‘superstars’ enjoy the bulk of the rewards. We evaluate the impact of CEOs achieving superstar status on the performance of their firms, using prestigious business awards to measure shocks to CEO status. We find that award-winning CEOs subsequently underperform, both relative to their prior performance and relative to a matched sample of non-winning CEOs. At the same time, they extract more compensation following the award, both in absolute amounts and relative to other top executives in their firms. They also spend more time on public and private activities outside their companies, such as assuming board seats or writing books. The incidence of earnings management increases after winning awards. The effects are strongest in firms with weak corporate governance. Our results suggest that the ex-post consequences of media-induced superstar status for shareholders are negative.

Acquiring-firm shareholders lost 12 cents at the announcement of acquisitions for every dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001, whereas they lost $7 billion in all of the 1980s, or 1.6 cents per dollar spent. Though the announcement losses to acquiring-firm shareholders in the 1980s are more than offset by gains to acquired-firm shareholders, the losses of bidders exceed the gains of targets from 1998 through 2001 by $134 billion. The 1998-2001 aggregate dollar loss of acquiring-firm shareholders is so large because of a small number of acquisition announcements by firms with extremely high valuations. Without these announcements, the wealth of acquiring-firm shareholders would have increased. The large losses are consistent with the existence of negative synergies from the acquisitions, but the size of the losses in relation to the consideration paid for the acquisitions is large enough that part of the losses most likely results from investors reassessing the standalone value of the bidders. Firms that announce acquisitions with large dollar losses perform poorly afterwards.

This article presents the growing research area of Behavioural Corporate Finance in the context of one specific example: distortions in corporate investment due to CEO overconfidence. We first

A risk-averse manager’s overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk. AVAST EXPERIMENTAL LITERATURE finds that individuals are usually overconfident in that they believe their knowledge to be more precise than it actually is. The incidence of overconfidence is likely to be even greater among CEOs than among individuals at large; for example, Goel and Thakor (2008) show that overconfident individuals are more likely to win the intrafirm tournaments that lead to the rank of CEO. Since overconfidence directly influences decision-making, it is logical to investigate the effects that overconfident managers have on corporate policies and firm value. How does overconfidence affect the investment decisions that managers make on behalf of shareholders? How do compensation contracts optimally adjust to these effects? Do firms benefit from managerial overconfidence? Can overconfidence ever benefit the biased

This paper introduces a decision-theoretic model of beliefs that allows for the possibility that what a person believes to be true is affected by what that person wants to be true. The substantive assumptions are (i) that distortion requires uncertainty, and that only payoffs over uncertain events matter, and (ii) that belief distortion over an event has to do with what a person has to gain or lose from the event being true. Using these assumptions I derive a simple formula with only one free parameter, which is positive for optimists and negative for pessimists. The key comparative statics are that belief distortion is greater in situation that are important and are where there is a great deal of uncertainty. The representation has the same structure as Bayes Rule, with payoffs playing the same role as normatively relevant information. A key implication is that news that affects the expected payoff consequences of an event may alter beliefs, even when it provides no relevant information about its likelihood.

Using the historical random assignment of MBA students to sections at Harvard Business School, I show that executive peer networks are important determinants of managerial decisionmaking and firm policies. Within a class, executive compensation and acquisitions strategy are significantly more similar among graduates from the same section than among graduates from different sections. Both executive compensation and acquisitions propensities have elasticities of 10-20 % with respect to the mean characteristics of section peers. I demonstrate the important role of ongoing social interactions by showing that peer effects are more than twice as strong in the year immediately following staggered alumni reunions. I further show that peer effects in compensation are not driven by similarities in underlying managerial productivity using a test of "pay for friend’s luck": pay responds to lucky industry-level shocks to the compensation of peers in distant industries.

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This paper documents a dramatic difference in the abnormal announcement period returns of the first bidder to announce an acquisition attempt in a particular industry. Typical of the literature, the set of all bidders in our sample earn abnormal returns indistinguishable from zero. However, bidders announcing an acquisition after a ‘dormant period ’ of at least a year without such activity in their industry, earn significantly positive abnormal returns of 0.8%. This contrasts with the insignificantly negative returns earned by bidders with shorter industry dormant periods. We also document that the prices of subsequent bidders adjust proportionately to returns of the initial bidder at the time of that initial announcement. In addition, bidder abnormal returns are significantly positively related to the length of the dormant period. These results provide strong evidence in support of the anticipation hypothesis. Our results hold after controlling for variables typically associated with bidding firm returns. 2 Anticipation Acquisitions and the Bidder Return Puzzle