Overconfident CEOs boost innovation, study says

Tuesday, July 13, 2010 - 9:46am
Tracy Moniz

If asked whether their new business will succeed, over 80 per cent of entrepreneurs believe that it will, even though most new ventures fold within five years. Research suggests that people routinely overestimate their abilities. But, is overconfidence such a bad thing?
A recent study by a U of T Mississauga management professor suggests that overconfidence may actually be good for business-that, specifically, having an overconfident chief executive officer may boost corporate innovation, one of the most important sources of economic growth.

Given the risk surrounding innovation, we believed intuitively that the psychology of top managers had to play a role in driving it, says Professor Alberto Galasso of the Master of Management and Innovation program, who co-authored the working paper with Professor Timothy Simcoe of Boston University. 

Their theory is that CEOs innovate to prove their ability, and so overconfident CEOs will be more likely to innovate because they underestimate their probability of failure. To test this, Galasso and Simcoe looked at a sample of 627 CEOs and 290 firms in the United States-large publicly traded companies primarily from manufacturing and technology industries-between 1980 and 1994 and found that overconfident CEOs do in fact innovate more. They spend about 15 per cent more on research and development; they hold more patents (a measure of innovation) and, specifically, 25 to 35 per cent more citation-weighted (and therefore more valuable) patents; and they are more likely to lead their firms in new technological directions. This impact is also stronger in competitive markets where success says more about a CEO's ability and leads to a larger payoff.

To measure overconfidence, the researchers relied on an existing model that classifies CEOs as overconfident if they choose not to sell their fully vested stock options when company stock prices spike, signalling their belief that stocks will climb even higher under their leadership. 

Prior studies suggest that overconfident CEOs tend to make poor business decisions: excessive and unprofitable mergers and acquisitions as well as overinvestment in infrastructure. Galasso's study helps explain why, despite this, overconfident managers still survive in industry. Simply put, they are better innovators, and innovation drives the economy-often with far-reaching effects. 

An innovating manager may have a beneficial impact not only on a company's profitability, but also on overall social welfare, says Galasso, who is cross-appointed to the Rotman School of Management. In some cases, the social benefit of innovation can be huge, such as developing a new drug that can save lives.