Overconfidence, Compensation Contracts, and Capital Budgeting

Posted: 7 Mar 2011 Last revised: 22 Nov 2020

See all articles by Simon Gervais

Simon Gervais

Duke University - Fuqua School of Business; Duke Innovation & Entrepreneurship Initiative

J.B. Heaton

One Hat Research LLC

Terrance Odean

University of California, Berkeley - Haas School of Business

Date Written: March 4, 2011

Abstract

A risk-averse manager's overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.

Keywords: overconfidence, capital budgeting, compensation, labor market

Suggested Citation

Gervais, Simon and Heaton, J.B. and Odean, Terrance, Overconfidence, Compensation Contracts, and Capital Budgeting (March 4, 2011). Journal of Finance, Vol. 66, No. 5, pp. 1725-77 (2011), Available at SSRN: https://ssrn.com/abstract=1777642

Simon Gervais (Contact Author)

Duke University - Fuqua School of Business ( email )

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HOME PAGE: http://www.fuqua.duke.edu/faculty_research/faculty_directory/gervais/

Duke Innovation & Entrepreneurship Initiative ( email )

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J.B. Heaton

One Hat Research LLC ( email )

Chicago, IL
United States
(312) 257-3900 (Phone)

HOME PAGE: http://www.onehatr.com/

Terrance Odean

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-642-6767 (Phone)
510-666-2561 (Fax)

HOME PAGE: http://www.haas.berkeley.edu/faculty/odean.html

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