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Overconfidence Bias and How to Avoid It


Posted on Aug 2017



Introduction

            The goal of the study is to assess overconfidence bias during acquisitions and mergers within an organization, especially at the managerial level and make recommendations on how it can be avoided. Overconfidence during the acquisitions and mergers is not something new. Over the years, the overconfidence bias has received huge audience from the media and scholars. For example, the case of Facebook purchasing Whats up at the cost $19 billion is considered by many experts as an overconfidence move, that might prove to be costly in the long-run. In the field of psychology, overconfidence tends to be connected to probability judgment and calibration. Most of the psychology studies focus on the issue of overconfidence from the positive illusions point of view. When people they have positive illusions about an issue they usually make mistakes as their decisions are informed by emotions rather than proper logical reasoning. According to Skala (2008), overconfidence can be defined as a particular type of miscalibration, whereby the probability relating to the given answer to a question being correct to exceed the appropriate level of the answers accuracy. Overconfidence bias results in individuals having unrealistic levels of confidence concerning their capabilities or a given opportunity; such as a manager being overconfidence concerning an investment opportunity due to bias.

            Overconfidence is seen in the field of management and finance, especially when managers are making investment decisions. Therefore, those who are overconfident to the extent of being over ambitious when making investment decisions and in the long-term, they end up being costly to an organization. In the past, many investment decisions, such as acquisition and mergers have failed due to the overconfidence of the management, especially on the capability of the firm remaining profitable (Kind and Twardawski 2016). Instead of using logic in making major decisions, most of the managers have used emotion and have ended up coming up with poor decisions. In the area of mergers and acquisitions most of the decisions that have been made by managers in large corporations have been impacted negatively by overconfidence, especially in their capabilities to make things work or financial capacity of the firm, rather than long-term benefits and cost implications of such decisions. Thus, there is need of looking at the concept of overconfidence in the field of finance, especially how they impact on acquisition as well as merger decisions within a firm.

            One of the major findings of this research is that overconfidence bias results in managers making the wrong decisions, in the course of determining what investment opportunities to take, such as available acquisition and mergers opportunities in the market. Overconfidence bias also results in managers overlooking post-acquisition issues, revenues and costs as well as considering available cash resources in a firm, instead of the viability of the project at hand (Doukas and Petmezas 2007). The findings of the study will assist managers in the future to avoid overconfidence bias when making decisions related to mergers and acquisitions.  

Literature Review

            Most the existing literature connected to overconfidence does not only focus on psychological aspect but looks critically at the how overconfidence bias impacts on corporate finance and financial markets. In the area of financial markets, overconfidence bias literature tries to explain anomalous findings on investors features and the way their decision-making process is impacted by overconfidence trait. On the other hand, when it comes to corporate finance, the existing literature mainly focuses on issues to do with acquisitions and mergers decisions, investment, and financing decisions.

            One of the major impacts of overconfidence is in the area of asset pricing. In recent years, various behavioral financial theoretical frameworks, which are based on the hypothesis of overconfidence, have been developed with an objective of explaining the effect of this psychological concept on stock returns. According to Moore and Healy (2008) overconfidence bias results into investors overreacting to private information, while at the same time under-reacting to available public information related to financial markets. Overconfidence results in investors trading in an aggressive manner in the market, and they tend to underestimate risks associated with making investments in riskier markets and securities. Brown and Sarma (2007) notes that overconfidence affects adversely the ability of an individual investor to make a sound judgment on when to make investments in the security markers and when not to do so.

            Skala (2008) notes that there is a gender difference when it comes to overconfidence on financial related issues, whereby, men are overconfidence when compared to women. On the basis of gender, men trade excessively in the stock markets compared to women. This shows that men while dealing with financial decisions are more likely to be overconfident and less cautious when compared to women. Overconfidence results in individual investors ignoring asset prices and this impact negatively on their returns; thus, overconfidence bias impacts on the ability of investors to generate higher returns as one becomes blind to prices that assets are being sold in the market (Croci, Petmezas and Vagenas-Nanos 2010). This shows that overconfidence makes investors or managers ignore issues to do with assets pricing by engaging in excessive trading with an objective of generating higher returns, ignoring the financial fundamentals of considering the viability of an investment opportunity before committing any money to it.

            Another focus of existing literature has been in the area of overconfidence among managers as far as corporate finance is concerned. According to Hribar and Yang (2013), there numbers of academic literature focusing on consequences of managers who are biased due to overconfidence have been growing. Hribar and Yang point out that biased managers usually handle investment and financing decisions in a completely different way when compared to managers who act in a normal way. Overconfident managers usually end up pursuing value, which in return destroy the benefits associated with acquisitions (Croci, Petmezas and Vagenas-Nanos 2010). Ferris, Jayaraman, and Sabherwal (2013) point out that overconfident manager's end up making poor judgments regarding earnings expected from acquisitions. The managers who are overconfident mainly put expected earnings from acquisitions as higher compared to non-confident managers. Therefore, the ability of managers to make accurate decisions concerning expected earnings from acquisitions and mergers is very poor due to their judgment being adversely affected by overconfidence. Kind and Twardawski  (2016) reveals that overconfident managers view acquisitions and mergers with optimism, while non-confident managers approach this critical financial process with a lot of caution. Hence, the high levels of optimism concerning acquisitions end up clouding their judgments concerning asset pricing and expected returns from an acquisition or merger investment.

            Doukas and Petmezas (2007) points out that overconfident manager are highly optimistic when making an investment as well as financial decisions. As a result, they end up misusing firm's cash in investment opportunities that do not make economic sense. The high levels of confidence result in judgment bias, as they view the investment opportunities likely to generate higher earnings, even when analysis indicates otherwise (Ferris, Jayaraman and Sabherwal 2013). The overconfident CEOs make errors when it comes to sourcing for finances to invest in various projects, such as acquisitions. The overconfident managers in a business largely depend on cash as source financing investment projects and this increases organizational risks of cash flow problems in the case, the acquired assets does not generate cash returns immediately. However, the non-confident CEO mainly looks for external sources of finance, such as equity as the basis of helping to raise money to be used in acquisitions and mergers (Brown and Sarma 2007). When it comes to purchases of shares, non-confident managers are less likely to purchase company shares in the market, as they underestimate their real value and fear incurring losses in the process, but overconfident managers have a higher probability of making company‚Äôs share purchases as they overestimate their real value in the market.

             Also, Libby and Rennekamp (2011) argue that overconfident managers overestimate the future earnings of a firm they intend to acquire when compared to their counterparts who are less confident. Therefore, when making future earnings forecasting they fail to be realistic ignoring factors that might negatively affect the earnings. The poor forecasting on earning results in the overconfident managers being biased as they ignore fundamental factors that should be considered when making earning forecasts within a firm, such as inflation, market trend changes and others. Goel and Thakor (2008) argues that overconfidence bias impacts on the capability of the manager to make sound decisions during the merger as well as acquisition process, as they ignore issues to do with post-merger, such as the impact on corporate governance and morale of the employees. 

            Ferris, Jayaraman, and Sabherwal (2013) point out that overconfidence bias when making acquisition decisions can be avoided by looking at the historical data of a company and making realistic earning forecasts. Also, the bias can be effectively addressed through carry out an adequate assessment of the firm being acquired through undertaking cost-benefit analysis as the basis for determining the best decision to take. This aids in eliminating bias that might arise due to the overconfidence of the management concerning the acquisition and merger process.

Main Ideas

 In the field of corporate finance, one of the biggest challenges that many organizations face is engaging in mergers and acquisition decisions that end up being unsuccessful in the long-run. According to Brown and Sarma (2007), overconfidence bias among senior managers involved in the process of making acquisitions decisions in a firm is what causes failure of most of the acquisitions in a firm. The literature review section of this research reveals some major issues relating to the effects overconfidence bias, it causes and how it can be addressed by individual managers.

 One of the major findings in this research is that overconfidence bias is a form of the psychological condition, whereby one has positive illusions concerning everything, even in situations when the negative illusion is needed (Skala 2008). Therefore, managers who are overconfident usually have a tendency of viewing everything in a positive way, such as viewing success in every acquisition project, even in a scenario where evidence is against such kind of illusion. Overconfidence bias, thus, becomes a hindrance to the ability of the managers to make sound judgment in various situations. For example, when a person is overconfident in life, it is difficult for the person to view things in a realistic way and most cases end up making a poor judgment in certain situations. This indicates that overconfidence among managers is a major threat to their judgment capacity within an organization and this threatens their abilities to make sound financial as well as investment decisions (Skala 2008).

 The major effect of overconfidence bias among managers about the concept of acquisition decision is they end up making costly mistakes. When a person is overconfident, the ability to use logic as the basis of making important decisions is impaired. This situation applies in the case of corporate finance, where managers abilities to make logical investment decisions is impaired by overconfidence (Goel and Thakor 2008). An organization cannot afford to make mistakes in the area of investment, as it ends up losing financial resources and in worst cases, it can collapse. This indicates that there is a danger of managers within an organization being overconfident. Most of the managers who not confident are extremely cautious when making investment decisions in the area of acquisition, and basis decisions on proper analysis and this help in eliminating some illusion mistakes. Thus, managers in modern day organizations should avoid being overconfident when making acquisition decision for purposes of making sound acquisitions (Goel and Thakor 2008).

 On the other hand, the reviewed literature indicates that overconfidence among managers during the acquisition process results in the destruction of value associated with this major financial decision in a firm. Overconfident managers usually overvalue an organization, as they view its shares being of higher value than they are supposed to be in reality if a careful fundamental financial analysis is carried out. Thus, there is a danger of CEOs of firms being overconfident, as they end up buying other firms at a higher price than they are supposed in reality (Brown and Sarma 2007). When making investment decisions, the basis for deciding on the price to pay for a firm acquisition should be based on a carefully concluded financial analysis of the firm being considered for purchase. However, when a manager has overconfidence bias, emotions instead of logic is what is used as the basis of arriving at major acquisition decision, and this is a costly affair as the firm end up paying more than it should for completing an acquisition. 

 Additionally, the major challenge associated with overconfidence when making acquisitions investment decision in corporate finance is an overestimation of earnings of a firm to be acquired or an asset. For example, a manager who is overconfident will end up making an unrealistic estimation of earnings to be generated using an asset or acquired firm, ignoring fundamental financial and economic factors that might impact on earnings in the future. Therefore, overconfidence result in a manager thinking in the unrealistic way when making future earnings forecast related to a particular acquisition (Libby and Rennekamp 2011). In situations where a manager overestimates future earnings expected from an acquisition, the final decision will end up being costly to the firm, as huge financial resources will be used in purchasing a firm that is unprofitable in the long-term.

            Also, overconfident managers make a mistake of using cash as a means of financing acquisitions, instead of looking for alternative sources of capital. This exposes a company to cash flow problems in the eventuality that the acquired organization is not profitable as expected. There is also the danger of ignoring corporate governance issues when a manager is overconfident during the process of making acquisition decision (Croci, Petmezas and Vagenas-Nanos 2010). It is critical to consider issues related to the impact of an acquisition of corporate structure, employee motivation and culture of a firm, so as to make a sound decision. Most of the firms have ended up failing due to poor acquisition decisions that ignore corporate governance issues. 

 Overconfidence bias can be dealt with using different ways. One of the best ways is being realistic when forecasting future earnings. Managers need to be realistic in forecasting expected returns from a firm that is to be acquired, especially considering all the possible scenarios so as to make sound investment decisions. The use of historical data can help to overcome overconfidence bias, as one can understand the trend of firm performance and use this as the basis for making future projections of what to expect regarding earnings and return on investment. 

Conclusion

            The main findings of this research is that overconfidence bias impacts negatively on the ability of managers within an organization to make sound financial as well as investment decisions, especially when considering acquisition and mergers. The managers are overconfident about their organization's capabilities to succeed through acquisitions and at times end up being unrealistic when considering certain decisions. One of the major effects of overconfidence biased as revealed in this research is an overestimation of expected returns from acquisitions (Brown and Sarma 2007). Hence, the manager ends up making unsound investment decisions which are not realistic in nature. This challenge can be dealt with through carrying out realistic of expected earnings from an acquired firm in the future.  Also, this research reveals that overconfidence makes managers make poor judgments as far as asset pricing is concerned. For example, due to poor judgment, most of the male managers who are more likely to be overconfident compared to women end up investing excessively in stock purchases, without considering asset prices, generating lower returns in the long-run. There is also the problem of overvaluing assets or firm being acquired when a manager is overconfident. This clearly shows that managers should avoid being overconfidence to eliminate judgment biases associated with this psychological condition. The research indicates that overconfidence bias can be dealt with during acquisitions by managers through undertaking realistic forecasting of earnings, careful assessment of the problem being address and use of historical data to predict future performance of an organization (Ferris, Jayaraman and Sabherwal 2013).

            The concept of overconfidence bias is important in the field management as well as finance. Given that managers are the ones responsible for authorizing acquisitions decisions within a firm; they are supposed to ensure that make accurate decisions without being overconfident as this affect their logical reasoning negatively. Therefore, the concept of overconfidence bias and its negative effects provide the basis of managers understanding the importance of being realistic while making major decisions within an organization. The concept help raises major questions regarding whether overconfidence within the right context can positively influence the success of a firm during mergers and acquisitions. This shows that future studies should focus on this area so that conclusive information can be gained on whether overconfidence positive influences mergers and acquisition decisions in a firm or its effects are only negative ones.