Ch. 4: Behavioral Corporate Finance 169
that subjects tend to believe themselves to be more likely than average to experience
positive future life events (e.g., owning own home, living past 80) and less likely to
experience negative events (being fired, getting cancer). Illustrating overconfidence in
one’s own skills,Svenson (1981)finds that 82% of a sample of students placed them-
selves in the top 30% in terms of driving safety.
There are good reasons to focus on these particular biases in a managerial setting.
First, they are strong and robust, having been documented in many samples, in particular
samples of managers (Larwood and Whittaker, 1977; March and Shapira, 1987; Ben-
David, 2004). Second, they are often fairly easy to integrate into existing models, in
that optimism can be modeled as an overestimate of a mean and overconfidence as an
underestimate of a variance. Third, overconfidence leads naturally to more risk-taking.
Even if there is no overconfidence on average in the population ofpotentialmanagers,
those that are overconfident are more likely to perform extremely well (and extremely
badly), placing them disproportionately in the ranks of upper (and former) management.
And fourth, even if managers start out without bias, an attribution bias—the tendency to
take greater responsibility for success than failure (e.g.,Langer and Roth, 1975)—may
lead successful managers tobecomeoverconfident, as inGervais and Odean (2001).
After reviewing the theory and evidence on optimism and overconfidence, we turn
briefly to potential applications of bounded rationality and reference-point preferences.
Given the state of the literature, our treatment there is necessarily more speculative.
Further, we do not discuss at all the impact of several other judgmental biases, such
as representativeness, availability, anchoring, and narrow framing—not because we be-
lieve them to be unimportant, but because no systematic studies of their impacts on
corporate finance decisions have yet been conducted.
3.1. Theoretical framework
The idea of managerial optimism and overconfidence in finance dates at least toRoll
(1986). The derivation below is in the spirit ofHeaton (2002)andMalmendier and
Tate (2005), as modified to match our earlier notation as much as possible. We start by
assuming the manager is optimistic about the value of the firm’s assets and investment
opportunities. He then balances two conflicting goals. The first is to maximizeperceived
fundamental value. To capture this, we augment fundamental value with an optimism
parameterγ,
( 1 +γ)f(K,·)−K,wheref is increasing and concave in new investmentK. Note that here, the manager
is optimistic about both the assets in place (f can include a constant term) and new
opportunities. Once again, if traditional market imperfections cause theModigliani and
Miller (1958)theorem to fail, financing may enterfalongside investment.
The manager’s second concern is to minimize theperceivedcost of capital. We as-
sume here that the manager acts on behalf of existing investors, because of his own stake