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Overconfidence, Compensation Contracts, and Capital Budgeting

Authors

  • SIMON GERVAIS,

  • J. B. HEATON,

  • TERRANCE ODEAN

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    • Simon Gervais is from Duke University. J. B. Heaton is from Bartlit Beck Herman Palenchar & Scott LLP. Terrance Odean is from the University of California at Berkeley. This paper is an updated version of a previous working paper, “Overconfidence, Investment Policy, and Manager Welfare,” by the same authors. The authors would like to thank Franklin Allen, Jonathan Berk, Bruce Carlin, David Denis, Robert Goldstein, David Ross, Jacob Sagi, Marti Subrahmanyam, Peter Swan, two anonymous referees, and the Acting Editor, David Hirshleifer, for their comments and suggestions. Also providing useful comments and suggestions were seminar participants at the Meetings of the European Finance Association, the Meetings of the American Finance Association, the NYU Stern Five Star Conference on Research in Finance, the Laurier Finance Conference, the Conference of the Financial Intermediation Research Society, Baruch College, Cornell University, Emory University, Insead, London Business School, London School of Economics, the University of Amsterdam, the University of British Columbia, the University of California at Los Angeles, the University of Florida, the University of Maryland, the University of Minnesota, the University of Oregon, the University of Toronto, Vanderbilt University, and the Wharton School. J. B. Heaton acknowledges that the opinions expressed here are his own, and do not reflect the position of Bartlit Beck Herman Palenchar & Scott LLP or its attorneys. All remaining errors are the authors' responsibility.


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.

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