Abstract
AbstractResearch summaryThis study examines how managerial biases in the form of overconfidence change the interpretation of performance feedback and, consequently, shape a firm's risk taking in response to it. Our formal analysis suggests that CEO overconfidence is associated with a lower willingness to increase firm risk taking when facing negative performance feedback and a higher willingness to decrease risk when facing positive feedback. An extension of our model also shows that, when firms are operating close to their survival level, the effects of CEO overconfidence will reverse. We test our predictions empirically with a sample of 847 American manufacturing firms in the years 1992 to 2014. Our results are consistent with our hypotheses and are robust to different empirical operationalizations of CEO overconfidence.Managerial summaryManagers evaluate the success of their current business strategy through feedback in the form of their firm's current financial results relative to their own previous performance or that of their peers. Our results show that overconfident CEOs interpret information about the financial situation of their firms more optimistically than non‐overconfident CEOs, which in turn causes them to exhibit a less pronounced reaction to both positive or negative performance feedback. It is thus crucial that managers are clearly aware of how their interpretations and reactions to feedback are affected by their own deeply held personal beliefs and dispositions.
Highlights
Firms assess their financial performance by comparing it to specific aspiration levels, which in turn strongly shapes their risk-taking preferences
Research summary: This study examines how managerial biases in the form of overconfidence change the interpretation of performance feedback and, shape a firm's risk taking in response to it
The primary objective of this study was to examine how managerial biases in the form of overconfidence change the interpretation of performance feedback and firm risk taking in response to it
Summary
Firms assess their financial performance by comparing it to specific aspiration levels, which in turn strongly shapes their risk-taking preferences. In the case of negative performance feedback, and μ0 = 2 in the case of positive performance feedback behavioral theory of the firm suggests that when performance falls short of aspirations CEOs engage in problemistic search, explore alternative strategies, and tend to exhibit higher risk taking in order to reach the aspiration level (e.g., March & Shapira, 1987; Wiseman & Bromiley, 1996), an overconfident CEO facing negative feedback might falsely believe that she is still in a situation where “locking in” the expected gains by choosing a low-risk strategy is the preferable and thereby perceives less need to increase risk. Hypothesis (H3) When firms are operating close to their survival level, the relationship between firm risk taking and negative performance feedback will be moderated by CEO overconfidence such that the effect of negative feedback on risk taking will be less negative for overconfident CEOs than for non-overconfident CEOs
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