When assessing CEO behaviour, most investors focus on what I would call “rational factors”: are CEO/CFO incentives aligned with shareholders’, do they have skin in the game, do they have the requisite skills and experience, do they have a successful track record, can they articulate a compelling strategic vision, might they be trying to deceive or manipulate shareholders, etc? Certainly these are relevant considerations.
In my experience, what tends to be overlooked are “irrational factors” – subconscious aspects of decisions – decisions that CEOs/CFOs might make with the best of intentions, but research evidence shows are, in fact, prone to systematic bias.
More biased than laypeople
While it might not seem like it based on our subjective experience, psychologists and neuroscientists have shown that a large portion of our mental processes occurs beyond our conscious awareness, and that these processes can be subject to various biases.
One important example that is particularly relevant for CEOs/CFOs is overconfidence. Just like the rest of us, CEOs/CFOs are prone to under-estimating the amount of uncertainty in their decisions. In fact, in this regard they seem to be more prone to bias than are laypeople. For example, when predicting stock market movements, one large-scale study found that CFOs who were asked to give 80% confidence intervals were surprised a massive 67% of the time (compared with the 20% of surprises they should have expected given an 80% confidence interval).
There is good reason to anticipate that CEOs, in particular, would be more overconfident than the rest of the population. Confident people tend to be viewed as more competent, perhaps allowing them to be promoted to the C-suite more quickly than their otherwise equally competent colleagues.
Also, the higher in the organization you go, the more difficult it can become to obtain the timely and specific feedback that is required to properly calibrate your confidence with reality. Not only might a CEO’s colleagues be more reticent in providing constructive feedback, but compared with their more junior colleagues, CEO’s decisions tend to be more complex and idiosyncratic, less repeatable, long-term and with results that are subject to an array of potentially confounding factors. In these circumstances the risk of overly attributing past success to superior skill rises, leading to increased risk of overconfidence about the success of future decisions.
Does CEO overconfidence matter?
Research evidence suggests that CEO overconfidence does matter. One study (by Hayward & Hambrick) showed a correlation between several measures related to CEO overconfidence (good recent company performance, recent praise for the CEO in the media, and a large gap between the CEO’s remuneration and the next most highly paid executive) were highly associated with the size of premiums paid by the CEO’s company for acquisitions.
This and other studies using a range of different measures of overconfidence suggest the types of contextual cues that investors should look for in annual reports, company communications and press reports to help identify overconfidence in CEOs/CFOs, as well as other relevant personality traits that can impact strategic and financial decision-making.
The research evidence shows that these types of measures can be linked to a range of important outcomes for shareholders, such as a company’s propensity to pay dividends, to repurchase shares, the amount of capital expenditure undertaken, and the amount and type of debt in the company’s capital structure, for example.
Beware of subconscious influence
Unfortunately, when it comes to subconscious decision-making errors, knowledge of them is often insufficient to change decisions and to change behaviour – whether you are a CEO or an investor. For example, as an investor, whether we like it or not, our automatic response can be to assume that any hesitance or uncertainty expressed by a CEO or CFO is a sign that either they don’t know what they are talking about or are trying to hide something. How can we have confidence to invest in a company when the CEO/CFO seemingly doesn’t have confidence themselves?
In contrast, when viewed through a behavioural finance lens, a CEO expressing hesitance might actually be a sign that they are well acquainted with the uncertainties they face, and that (compared with overconfident CEOs) their decisions are more likely to be aligned with their company’s relevant commercial and financial realities.
What can you do?
When dealing with subconscious biases, often the standard approaches and interpretations will not work. Aligning management incentives, for example, will not necessarily help an overconfident CEO to make less overconfident decisions. The problem is not one borne of insufficient or misaligned motivation.
But the fact that subconscious mental processes occur beyond our awareness doesn’t mean they are completely immune from the objective assessment of a savvy investor. A general takeaway is that professional investors should focus on the efficacy of a company’s strategic or financial decision-making processes in dealing with a range of well-documented decision-making biases.
Do a company’s processes capture sufficient granular decision-making data to allow for effective feedback – the type that can properly calibrate and debias decision over time? Are collective decision-making processes (particularly key governance-related ones) tailored to capture the benefits and avoid the pitfalls of group decision-making? Do they effectively integrate human and mechanical decision-making to capture the benefits (and mitigate the deficiencies) of both?
Having good answers to these questions doesn’t necessarily mean the company free of problems, of course. But good answers would indicate a company that takes effective decision-making seriously.
Simon Russell is the Director at Behavioural Finance Australia.