CEO Overconfidence and Strategic Flexibility:Evidence from Real Options Investment

While real options theory has been applied with the rationality assumption, the actual real options investments are made by managers, who are often subjective to cognitive biases, especially under uncertainty. In this paper, we focus on one important type of cognitive bias, overconfidence, to provide new insights on real options literature. We argue that an overconfident cognitive bias will impede CEOs from effectively evaluating the magnitude of the uncertain environments and/or will make them overestimate their capability to perform under uncertainty, resulting in CEOs investing less in firm-level strategic flexibility. Hence, we predict that overconfident CEOs will invest less in real options than other CEOs. We also predict that the relationship between overconfident CEOs and firms’ real options intensity will be strengthened when market uncertainty is higher. We test our arguments using a sample of US public firms covering the 17-year period from 1997 to 2013. We find strong support across various tests that use multiple measures of CEO overconfidence and real options intensity and control for potential selection issues and other endogeneity concerns.