Measuring C.E.O.'s on the Hubris Index

Published: May 22, 2005
EXCESSIVE pride has been bringing men down at least since ancient Greece. Only recently, however, have researchers begun to study whether hubris explains the otherwise mysterious behavior of corporate chief executives.

Why, for example, are some corporate leaders more likely than others to pursue mergers and acquisitions? This question has long puzzled financial theorists, since the nearly universal conclusion of past research is that mergers and acquisitions have poor odds of success. When M.& A. activity does create value, most previous studies have shown, it accrues almost completely to shareholders of the target company rather than to those of the acquiring firm.

If we assume that chief executives act rationally, as most theorists up until now have done, it is difficult to explain why so many mergers and acquisitions nevertheless take place.

But what if at least some chief executives act irrationally? That was the question posed by a recent study, which looked to see whether mergers and acquisitions are being disproportionately pursued by corporate leaders with the arrogance to believe that they can beat the odds.

The study's authors are Ulrike M. Malmendier, an assistant professor of finance at the Graduate School of Business at Stanford University, and Geoffrey A. Tate, an assistant professor of finance at the Wharton School of the University of Pennsylvania. Their study, which has circulated since last fall as a National Bureau of Economic Research working paper, is available at's_Research.html.

Answering this question was not easy, since overconfidence - like most psychological attitudes - can't be directly measured. The professors had to find observable behavior that was unambiguous evidence of this psychological trait. They settled on the timing of a chief executive's decision to cash in his stock options.

The typical stock option that a company grants its chief executive does not expire for many years, and once it vests he can exercise it at any time. He could do so immediately after the option moves significantly "into the money," for example; once the underlying stock moves well above the option's exercise price. If he exercises then and immediately sells the acquired shares, he will lock in a sizable profit. At the other extreme, he could hold the option until it nears expiration, in hopes that the stock price will go even higher. But then he takes the risk that the stock price will fall.

The professors categorize a chief executive as overconfident if he holds on to his options even after they have moved significantly into the money and exercises them only when there are 12 or fewer months left before expiration. They reason that in such a case he must be supremely confident in his ability to cause the price of his company's stock to go higher.

Waiting so long to exercise options, the professors said, is also a sign that a chief executive is probably not very concerned about risk. That's because his portfolio will probably be too concentrated once his options move significantly into the money. Even if his company's stock continues to rise in price, according to modern portfolio theory, the risk-reward trade-off of holding on to his options will most likely be inferior to that of exercising the options and investing the proceeds in a diversified basket of stocks.

To test whether chief executive overconfidence helps to explain merger and acquisition activity, the professors studied a database of 400 of the largest publicly traded corporations from 1980 to 1994. They focused on this database because it contained reliable information on when the companies' chief executives exercised their options.

The researchers divided the companies in this database into two groups according to the timing of those option exercises. The first group contained companies whose chief executives on at least one occasion waited to exercise in-the-money options until there were fewer than 12 months left until expiration - a sign that the chief executives were overconfident. The second, a control group, contained the remaining companies.

They found a big difference. The group containing companies led by overconfident chief executives was 1.65 times more likely than the control group to merge with or acquire another company.

This in itself would be compelling evidence that chief executive overconfidence is a major cause of mergers and acquisitions, but they found more. A particularly telling result emerged when the professors focused on what is referred to as diversifying mergers or acquisitions. These occur when the target firm is in a different industry than the acquiring firm. Diversifying mergers and acquisitions have an especially poor track record, and investors usually react negatively to them - a reaction that previous researchers have dubbed the diversification discount.

The professors suspected that it takes a chief executive with a lot of hubris to proceed in the face of the poor odds. Sure enough, they found that chief executives who satisfied their definition of overconfidence were 2.54 times more likely to pursue a diversifying merger or acquisition than those in the control group. That's more than 50 percent higher than the frequency with which overconfident chief executives pursued mergers and acquisitions generally.

THE professors interpret their findings as providing strong empirical confirmation of a comment that Warren E. Buffett made in the 1981 annual report for Berkshire Hathaway.

"Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess," Mr. Buffett wrote. "Consequently, they are certain their managerial kiss will do wonders for the profitability" of the companies they intend to acquire. But, Mr. Buffett added: "We've observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads."

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: