Half Full, and Then Some

Last year Simon Gervais, of Duke University, and Itay Goldstein, of the University of Pennsylvania, made a case for the virtues of overconfidence. They wrote in the Review of Finance that people who overestimate their skills tend to work harder and be more productive in order to meet their own expectations. They also contend that overconfident executives inspire their colleagues and, contra Ben-David, argue that they can be valuable when negotiating mergers. Those with an inflated sense of their company's worth will drive a hard bargain and, whether buying or selling, are more likely to get the best deal.

Perhaps John Maynard Keynes made the most forceful case for confidence when he wrote, "Individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits." The eminent British economist observed that successful businessmen embrace a "naive optimism" and must put aside the thought of ultimate loss, just as healthy men put aside the thought of death.

Ultimately it might be a matter of kind rather than degree. Confidence comes in various shades, making it both an asset and a liability for an executive, depending on the situation. Finance chiefs often consider self-assurance to be a core competency. "We accept what these CFOs are saying," says Schrand. "The positive benefits of overconfidence for some tasks might outweigh the negative consequences for other tasks."

A healthy dose of confidence, of course, is the glue of the markets. A failure of confidence can result in that perennial Wile E. Coyote sight-gag, where momentum meets gravity. The crash of Bear Stearns in March was the result of a "lack of confidence, not a lack of capital," according to SEC chairman Christopher Cox.

For companies, the missing factor in the confidence equation might be self-awareness. As York notes, executives must be good at gathering information from many sources and listening to what they are told. Better stress testing of potential outcomes can improve decision making, and knocking more heads together can dislodge stubborn certainty. Like everything else, overconfidence must be factored into the overall management picture. "It's not that overconfidence is bad," says Schrand. "It's that it should be recognized."

Alan Rappeport is a reporter at CFO.

Warning Signs

Hallmarks of companies with overconfident CFOs

• Use lower discount rates to value cash flows
• Invest more
• Use more debt
• Less likely to pay dividends
• More likely to repurchase shares
• Use proportionately more long-term debt

Source: "Managerial Overconfidence and Corporate Policies," by Itzhak Ben-David, John R. Graham, and Campbell R. Harvey. NBER Working Paper Series, 12/07

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