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OPINION

Over-confidence & investment

Over-confidence & investment
December 13, 2010
Over-confidence & investment

The link here is over-confidence, as described by Ulrike Malmendier at the University of California Berkeley. She's shown that, in the US, chief executives who are over-confident are disproportionately likely to increase their capital spending when they have the cashflow to do so. When retained profits are high, CEOs are less constrained by having to explain their decisions to sceptical banks or capital markets, and so have more freedom to indulge their over-inflated belief that they can identify profitable ventures and manage them successfully.

And here's the thing. It's possible that, going into 2011, CEOs are unusually over-confident.

Of course, they are selected for over-confidence in the first place; shrinking violets don't often get to the top of greasy poles. But the recession is likely to have magnified this even further.

For one thing, the CEO whose firm has survived the recession in good shape could well interpret this as (further!) evidence of his managerial skill. Such an inference, however, might not be warranted. Paul Gregg and Paul Geroski's classic study of the last recession found that only a minority of firms suffer badly in recessions anyway, and these are by no means necessarily poor performers.

Also, one effect of the recession has been to reduce support for the efficient market hypothesis. This will tempt bosses of firms that are out of favour with the stock market to infer that this is a sign not that their prospects are grim, but rather that investors are just plain wrong. This too could tempt them to trust their over-optimistic judgement rather than that of the market.

This raises the possibility that firms could go a spending spree even though there are few good profitable opportunities, because bosses' over-estimate their chances of success.

This will not necessarily be bad for the economy in aggregate. For firms supplying capital equipment, it is of little consequence whether demand for their goods is entirely rational or not. And workers who are employed to work on those new projects will spend their wages in the wider economy. Company spending, as well as government spending (perhaps more so), can have beneficial multiplier effects.

It might, however, have adverse effects for the individual firms undertaking such investment. Come 2012 or later, we might discover that some of 2011's investments have not been as justified as bosses pretended at the time. Now, more than usually, equity investors should be sceptical of companies undertaking significant expansions.