Abstract

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

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