Chief Executive Officer Overconfidence and Firm’s Investment Decisions: Evidence from Russia

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ФЕДЕРАЛЬНОЕ ГОСУДАРСТВЕННОЕ АВТОНОМНОЕ ОБРАЗОВАТЕЛЬНОЕ УЧРЕЖДЕНИЕ

ВЫСШЕГО ОБРАЗОВАНИЯ

"НАЦИОНАЛЬНЫЙ ИССЛЕДОВАТЕЛЬСКИЙ УНИВЕРСИТЕТ

"ВЫСШАЯ ШКОЛА ЭКОНОМИКИ"

Факультет экономических наук

Образовательная программа "Стратегическое управление финансами фирмы"

МАГИСТЕРСКАЯ ДИССЕРТАЦИЯ

CEO Overconfidence and Firm's Investment Decisions: Evidence from Russia

Выполнил: Морковкина Евгения Владимировна

Научный руководитель: доцент, к.э.н. Степанова

Анастасия Николаевна

Москва

2016



Contents

Abstract

Introduction

1. Theoretical background and recent empirical findings

1.1 CEO overconfidence and optimism

1.2 Previous research on relationship between CEO overconfidence and investments decisions

2. Empirical study

2.1 Methodology and model

2.2 Variables and CEO overconfidence index construction

2.3 Sample and data

3. Results

3.1 Descriptive data analysis

3.2 CEO overconfidence and firm's investment level

3.3 Board's role in investment decision-making

3.4 Robustness checks

Conclusion and discussion

References

Appendix 1. Data analysis. Tables & graphs

Appendix 2. Model predictions and robustness check. Tables



Abstract

The current study investigates the relationship between CEO overconfidence behavior and firm's investment level taking into account the board's monitoring and advising role. The latter is an additional one to traditional board's functions proposed by agency theory. The paper provides empirical evidence for interaction between biased CEO and the board of directors in the framework of decision-making process on capital investments inside 88 large publicly traded Russian firms. Following procedure of construction of CEO overconfidence score the study reveals that firms under overconfident CEO tend to invest heavier. Moreover, despite monitoring functions prescribed to the board Russian directors collaborate with overconfident CEOs due to similarity in their personal characteristics, educational background and experience that lead them to the similar decisions. Thus, the board of directors loses some degree of influence on CEO's intension to promote growth in firm's capital investments causing the problem of "powerful managers". Wherein, CEO's motives for increasing firm's investment level occur due to their own personal characteristics, education and experience, enhancing the degree of their overconfident behavior, rather than the board's advice.



Introduction

Corporate managers may be more overconfident than general population because of selection bias. This opinion is proposed by Gervais, Heaton and Odean (2003) who argue that only overconfident and optimistic persons about their professional skills, talents and career prospects have great chances to take highly competitive positions of top managers. At the same time, firms tend to hire overconfident and optimistic individuals if they perceive such characteristics as a sign of great talents (Gervais et al, 2003). Moreover, Graham, Harvey and Puri (2013) have discovered that CEOs naturally are more optimistic than American population on the average.

Thereby, it is reasonable to consider managers as vulnerable to behavioral biases because they take great responsibility for decisions made in relation to strategy, investments and financing policy of firm, they are forced to make important complex decisions in time luck conditions. Moreover, the quality of these decisions has a huge impact on firm's profitability and value (Graham et al, 2013; Azar, 2014) - managers do matter in firm's operations (Baker, Wurgler, 2012).

A number of empirical studies support the idea that companies with overconfident managers invest more than peers with less confident CEOs (Malmendier, Tate, 2005; Hackbarth, 2008, 2009; Chen, Lin, 2013; Hirshleifer et al, 2012). Also managerial overconfidence may be beneficial for the companies that tend to underinvest since such CEOs underestimate risks and overestimate good outcomes involving in high risky projects with high returns (Goel, Thakor, 2008; Chen, Lin, 2013; Hirshleifer et al, 2012). However, excessive investments should be suppressed by the board of directors who is authorized to control and monitor decision-making process of CEO alongside with agency theory. At the same time recent papers (McCahery, Vermeulen, 2014) promote additional board's role of strategic adviser which implies advising top-management on strategic issues and initiating their own ideas, changes.

According to earlier proposals the main research question of the study is how managerial overconfidence in the person of CEO affects corporate investment decisions in Russia and what is the board's of directors role. The problem of managerial biased behavior is multidisciplinary and relates to the both psychology and corporate finance areas. Its novelty originates from the fact that such behavioral bias as overconfidence becomes one more reason for explanation of corporate decisions made on top-management level. Biases on cognitive level shed light on those roots of the decisions made by managers that cannot be interpreted by traditional and objective factors. Moreover, the specificity of Russian emerging market with rather short history of corporate governance headed by the board of directors adds interest to researching decision-making hierarchy in the firm.

In the framework of current paper the proposed relation is tested with the sample of 88 large Russian companies from nonfinancial sectors. Using personal characteristics of CEOs (age, tenure, educational background, position duality, industry experience, entrepreneurship) as proxies for biased behavior CEO overconfidence score was constructed. Regression analysis revealed that Russian companies under overconfident CEOs make higher investments. Moreover, overconfident CEOs have some degree of influence and power in making investment decisions giving them a rise. Their motives for enlarging firm's investment level originate from their own characteristics, education and experience rather than from the board's advice.

The current study contributes to the existing literature on relationship between managerial behavioral biases and firm's corporate decisions, first of all, by taking under analysis Russian market with unsettled market traditions, secondly, by analyzing the board's reaction to biased behavior of top- management embedding their role into corporate decision-making process, thirdly, by approximating managerial overconfidence through their personal characteristics, education and experience that requires significant "efforts costs" on collecting data and, finally, by constructing unique CEO overconfidence index reflecting their level of overconfidence through a single score and eliminating the problem of overloading regressions by vast number of independent variables.

The paper is organized in a following way. Section one will be devoted to the description of the most popular type of behavioral biases - overconfidence and close to this phenomenon optimism. This is followed by the literature review related to the relationship between managerial overconfidence and firms' investments and to the board's participation in this decision-making process, appropriate hypotheses are stated. Section two covers the research methodology, data description and explanation of variables suggested to exploit including CEO overconfidence score construction. Final part discovers descriptive statistics of variables, the main results of the empirical research and concluding remarks.



1. Theoretical background and recent empirical findings

1.1 CEO overconfidence and optimism

Biases in managers' behavior arise because of not just imperfections and inefficiency of markets where their firms operate but also due to their irrationality (Kahneman, Riepe, 1998; Baker, Wurgler, 2012). This irrational behavior is expressed in systematic and random errors in managers' beliefs, preferences, judgments, decisions. Permanence of biases is a characteristic allowing categorizing them into cognitive illusions that arise systematically in decision-making processes and emotional ones appearing from time to time in most cases (Kahneman, Riepe, 1998). Cognitive illusions are paid more attention by researchers - both economists and psychologists, than emotional biases. Cognitive biases from psychological point of view refer to human thinking - how an individual perceives happening events, facts, estimate them and make a certain decision (Kahneman, Tversky, 1977; Kahneman, Riepe, 1998; Ritter, 2003; Baker, Wurgler, 2012). Kahneman and Riepe (1998) cognitive biases call biases of judgment and emotional ones - biases of preferences.

Managerial overconfidence is one of the most popular behavioral biases that originates from psychological phenomenon "better-than-average" effect (Malmendier, Tate, 2005; Shu et al, 2013). This effect implies that individuals believe themselves to be more skillful or "better" than others (Svenson, 1981; Kruger, 1999; Alicke et al, 1995) due to lacking information about other people comparable with them alongside particular characteristics. This self-attribution bias makes people estimate their own abilities, prospects more favorably and positively than another's (Alicke et al, 1995). Consequently, this imparts a certain degree of confidence to a person and boosts his self-appraisal. "Better-than-average" effect appears prevalent for CEO position since managers have no comparison group to evaluate objectively their real skills; result of their work can be measured only by company's performance and managers have an illusion that it predominantly depends on their decisions. This is putted into practice when CEO overestimates their abilities to make projects generate returns (Malmendier, Tate, 2005; 2008; Shu et al, 2013; Mohamed et al, 2014) or underestimates liquidity and financial risks of these projects (Wei et al, 2011; Baker, Wurgler, 2012).

Another form of overconfidence is miscalibration defined by Ben-David, Graham and Harvey (2010) as excessive confidence about having accurate information (Ben-David et al, 2010). Miscalibrated managers may overestimate the precision of their forecasts related to the future firm's earnings or underestimate the variance of risky processes (Baker, Wurgler, 2012). Moreover, authors refer illusion of control to overconfidence, however, this phenomenon will be considered later under optimism.

Besides, such cognitive bias as hindsight may also become the cause of overconfidence (Kahneman, Riepe, 1998; Biais, Weber, 2009). This phenomenon fosters illusion that most things are more predictable than it actually making individuals be overconfident about their prediction abilities. Individuals tend to exaggerate their abilities to estimate the probability of a particular event before it happens (Kahneman, Riepe, 1998), in other words, they consider past events more predictable than they seemed before they occur. This bias is caused by imperfections of human memory; hindsight-biased people recollect their initial predictions about an event after its occurrence as much as closer to reality even though these predictions were too far from true realization of the event (Fischhoff, 1975; Biais, Weber, 2009).

Overall, Shu, Yeh, Chiang and Hung (2013) prove why overconfidence in all its forms is inherent to top managers. Managers as skilled and competent persons working for a particular firm and limited by their managerial team have no comparison group, they are not able to evaluate objectively their real skills, talents (Shu et al, 2013), and consequently, they tend to be overconfident. Moreover, managers do not have one definite and concrete aim of their operating in the company, the result of their efforts can be estimated through the firm's outcomes (Moore, Kim, 2003; Shu et al, 2013) which are subject in addition to other influences. This also makes managers be confident about their performance - they may attribute good outcomes to their efforts and bad ones refer to other outside factors (Baker, Wurgler, 2012). And finally, managers overestimate their skills because they believe that firm's performance, predominantly, good is under their control, depends on their decisions (Ritter, 2003; Shu et al, 2013). Baker and Wurgler (2012) add that overconfidence appears in managers' behavior due to complexity of decisions made by them (Baker, Wurgler, 2012).

Managerial overconfidence in decision-making processes leads to different consequences - not only for managers themselves but also for firm's performance which depends on managers' decisions. However, in order to test managerial overconfidence effect it is necessary to model it, to select a certain proxies. Empirical studies exist in both developed and emerging markets that find concrete proxy-indicators for modeling overconfidence and analyze its influence on different managers' decisions and firm's outcomes. Table 1 present summary of empirical papers devoted to modeling managers' overconfidence and testing its effects.

The basic measures for managerial overconfidence are managers' personal portfolio transactions related to holding and exercising options (Malmendier, Tate 2005; Croci et al, 2010; Mohamed et al, 2014). Besides, personal managers' characteristics (Wei et al, 2011) and their abilities to forecast future earnings and volatility of returns (Xia et al, 2009; Ben-David et al, 2010) may also serve as overconfidence proxies.

Table 1. Summary of empirical papers devoted to modeling managerial overconfidence

Author	Journal	Market/Country	How to measure?
Developed markets
Barber, Odean (2001)	The Quarterly Journal of Economics	USA	Gender diversity as proxy for overconfidence: men are more overconfident than women and, correspondingly, trade more and perform worse
Malmendier, Tate (2005); Mohamed, Fairchild, Bouri (2014)	Journal of Finance Journal Of Economics, Finance And Administrative Science	USA	CEOs' personal portfolio transactions: 1) Overconfident CEOs exercise options later than suggested by the benchmark 2) Overconfident CEOs hold options all the way to expiration 3) Overconfident CEOs tend to increase portfolio of the company's stocks
Oliver (2005)	Working Paper	USA	Consumer Confidence Index as measure of the level of confidence
Malmendier, Tate (2008); Shu, Yeh, Chiang, Hung (2013)	Journal of Financial Economics International Review of Finance	USA Taiwan	1) CEOs' personal overinvestment in their company 2) `Press-based' measure - how outsiders perceive the CEO (the number of positive words is compared to the number of neutral or negative words)
Li, Hung (2013)	Review of Pacific Basin Financial Markets and Policies	Taiwan	Managers' net purchase of shares ratio
Ben-David, Graham, Harvey (2010)	The Quarterly Journal of Economics	USA	CEOs forecasts of future returns volatility
Emerging markets
Xia, Min, Fusheng (2009)	Frontiers of Business Research in China	China	Announced earnings forecast in the companies under overconfident CEOs is higher than its actual earnings
Tomak (2013)	International Journal of Economics and Financial Issues	Turkey	Consumer Confidence Index as measure of the level of confidence
Wei, Min, Jiaxing (2011)	China Finance Review International	China	Personal characteristics of CEOs as proxies of overcon?dence: younger CEOs , with shorter tenure, lower education, with an economic or ?nancial educational background, dualistic role of chairman of the board are overconfident

Close to overconfidence type of managerial bias is optimism. Ben-David, Graham and Harvey (2010); Baker and Wurgler (2012) differ optimism from overconfidence though many researchers match these issues and define the former as overestimating of a mean ability or outcome (Baker, Wurgler, 2012; Ben-David et al, 2010). The basic psychological cause of optimism is illusion of control; people exaggerate the degree of their control under a particular situation and underestimate the role of chance (Weinstein, 1980; Kahneman, Riepe, 1998; Baker, Wurgler, 2012).

Moreover, individuals are more optimistic about outcomes over which they suppose they have control (Kahneman, Riepe, 1998; Heaton, 2002).

In relation to managers, they tend to not take into account some degree of uncertainty in the processes referring to firm's performance and wrongly suppose that they possess a large amount of control over firm's operating (Heaton, 2002). In turn, March and Shapira (1987) suppose that managers become victims of the "illusion of control" because they underestimate the probabilities of failure (March, Shapira, 1987).

Aside from the illusion of full control, managers are optimistic about firm's performance because they themselves strive to their firm's success (Heaton, 2002). Their commitment to good outcomes is explained by their wealth, reputation and compensation dependence on the firm's performance.

Table 2 presents the summary of modeling optimism in empirical papers in both developed and emerging markets.

Table 2. Summary of empirical papers devoted to modeling managerial optimism

Author	Journal	Market/Country	How to measure?
Developed markets
Heaton (2002)	Financial Management	Theoretical	Optimistic managers systematically overestimate the probability of good firm performance and underestimate the probability of bad firm performance
Glaser, Schafers, Weber (2008)	Winner of the "Best Paper Award 2008"at the 15th annual meeting of the German Finance Association (DGF)	Germany	Transactions of managers on their personal accounts: the number of purchases, the number of sales, the volume of purchases, and the volume of sales
Campbell, Gallmeyer, Johnson, Rutherfor, Stanley (2011)	Journal of Financial Economics	S&P firms	Firms with optimistic CEOs are in the top quintile of firms sorted on industry-adjusted investment rates
Shu, Chiang, Lin (2012)	The Journal Of Behavioral Finance	Taiwan	Optimistic managers tend to issue more financial forecasts than their counterparts. The proxy of managerial optimism is whether the IPO firm issues financial forecasts around the years of IPO application
Tsinani, Sevic, Maditinos (2012)	Journal of Business Management	Greece	Transactions of managers on their personal accounts: the number of purchases, the number of sales, the volume of purchases, and the volume of sales
Chen, Lin (2013)	Multinational Finance Journal	Taiwan	High-optimism CEO indicator is dummy variable that equals 1 for all years if the CEO exercises stock options at (or more than) 100% moneyness at least twice for the studied period, and 0 otherwise
Emerging markets
Barros, Silveria (2007)	Brazilian Review of Finance	Brazil	Managers who is also an entrepreneur tend to be optimistic and overconfident; Managers that invest too heavily in their firms are optimistic

As optimism is a bias alongside with overconfidence it may lead suboptimal decisions that is very essential for economic and, in particular, financial sphere (Puri, Robinson, 2007). It is necessary to highlight that overconfidence and optimism often go with each other and then cannot be separated (Kahneman, Riepe, 1998; Barros, Silveria, 2007). The combination of overconfidence and optimism is a "potent brew" that provokes people, on the one hand, to overestimate their skills and knowledge and, from another hand, underestimate risks, magnifies their abilities to control events (Kahneman, Riepe, 1998).

Researchers pay attention to the fact that overconfident and optimistic managers are influential in corporate decision-making processes (Goel, Thakor, 2008; Barros, Silveria, 2007). The effects of managerial biased behavior on the firm's investment decisions will be analyzed in the next section.

1.2 Previous research on relationship between CEO overconfidence and investments decisions

Considering the distribution of responsibilities within the company it can be concluded that decisions related to real investments (capital investments) involve mainly CEO, his team, company's departments and board of directors. The last body plays a controlling role, while managerial team and departments provide support in different ways. In this process CEO is mainly an initiator of investments (Gцtze et. al, 2015). Therefore CEO's personal characteristics and cognitive biases are likely to have an impact on company's investments.

2.2.1 CEO overconfidence and investments

The problem of managers' overinvestment may be interpreted doubly. On the one hand, manager's role of entrepreneur, founder or simply owner of firm's equity by itself means investment activity that may appear too heavy. At the same time, firms headed by overconfident and too optimistic managers may be involved into overinvestment.

According to Markowitz and Sharpe theories rational investors maximizing their profits need to hold well-diversified portfolios. However, managers tend to invest heavily in the firms they work for breaking the rule of high diversification. Such managerial behavior may be classified as too optimistic and managers themselves are overconfident because they strongly believe that the firms under their managing perform well and have prosperous perspectives (Benartzi, 2001; Barros, Silveria, 2007). Besides, managers' heavy investments in their firms look irrational or even anomalous because in this case managers are exposed to most risks related to the firms' performance, moreover, their careers are closely linked to the firms' success they work for (Gervais et al, 2002; Barros, Silveria, 2007).

On the other hand, managers' excessive investments may be justified by insider information they posses about real firm's results and prospects that has not been incorporated into current firm's stock prices (Barros, Silveria, 2007). But managers should dispose of these investments when all the information is incorporated in the firm's securities market prices and transform from private into public, if they continue to keep high level of their firm's investment then their behavior becomes irrational and may be a sign of overconfidence and excessive optimism. Besides, Malmendier and Tate (2005) propose that managers can purchase their firm's stock setting the signal to the market about potential successful prospects for their businesses. However, if they do so this does not necessarily confirm their intension to make just a signal to potential investors; this may be simply a sign of managerial optimism and overconfidence because stocks repurchase is less costly for achieving the same purposes (Barros, Silveria, 2007).

From the viewpoint of theory devoted to conflicts of interest between managers and outside investors keeping large volumes of stocks from manager's own firm may evidence about private benefits of control if the manager is controlling shareholder (Barros, Silveria, 2007). However, the question about high level of stocks holding that exceeds the necessary and sufficient one for assuring managers' rights to control their business remains open. Clearly, CEO's power rises and abilities to impose his/her opinions and viewpoints on the firm become greater when CEO is also the owner of the business (Boubaker, Hamza, 2014). Consequently, managerial participation in the firm's equity may serve as proxy of overconfidence.

Moreover, a manager's status as one of entrepreneurs or founders of the business may influence his or her degree of optimism and overconfidence. Adams, Almeida and Ferreira (2005) propose that founder's status of managers make them think that they are powerful and influential in relation to the firms' decisions. Entrepreneurial startups heading by founder and manger rolled into one are often characterized by a significant level of risk, and according to surveys majority of entrepreneurs expect the positive development of their startups, while only 5-6% expect difficulties (Cooper et al., 1998; Landier, Thesman, 2009). However, only half of all startups survive more than three years (Scarpetta et al., 2002). Therefore, there is some evidence of miscalibration of entrepreneurs.

Alongside with this viewpoint Barros and Silveria (2007) state the hypothesis that managers who have also the status of an entrepreneur that is who run their own business tend to be more optimistic and overconfident than non-entrepreneur colleges. Founders of their own businesses have hypertrophied feel of control and responsibility, moreover, self-employed individuals have a bias to overestimate the probability of success, potential profits and also underestimate probable failure of the projects under their management (Barros, Silveria, 2007).

However, managers' biased behavior may "infect" other members of top management that results in appearing overinvestment in the firm's strategy. Using the real options model Hackbarth (2008; 2009) found that managerial optimism and overconfidence induce managers to expedite investing. In turn, Chen and Lin (2013) studied the relation between managerial optimism and investments, and then analyze these two variables' effect on firm valuation. The authors measured optimism basing on stock option holdings and exercise data and obtained results that firms with a highly optimistic CEO will invest more. Moreover, among Chinese listed firms those who are led by overconfident managers have greater possibilities to overinvest and this fact is determined by availability of cash flow from financing (Xia et al, 2009). And, finally, Eichholtz and Yonder (2015) discovered that overconfident CEO promotes corporate investment activity of their Real Estate Investment Trusts in (REITs) in The USA. REIT led by overconfident CEO invest 5,7% more than its peer headed by nonoverconfident counterpart, however, properties disposal rate in such firm is significantly lower.

There is evidence of positive influence of overconfidence not only on capital investments, but also on R&D investments, that are more innovative and riskier. Hirshleifer, Low and Teoh (2012) used two different measures of overconfidence: option-based (by average moneyness of options, and CEO's decision) and press-based (number of articles containing words related to confidence and caution). It was found that both proxies of overconfidence have a significant positive impact on R&D.

What is more, overconfident managers with their intension for heavy investments play more significant role in less financing constrained firms (high cash dividends payouts, low interest expenses relative to earnings, cash surplus) as investment - cash flow sensitivity is higher (Lin et al, 2005). Researchers proved this fact on Taiwanese firms and found that firm's cash flow has positive influence on investment activity suggesting that overconfident managers are willing to invest more when internal funds are available (Lin et al, 2005).

Similar results were obtained by Ben Mohamed, Fairchild and Bouri (2014) related to American industrial firms, authors concluded that managerial optimism increases investment sensitivity to cash flow of totally constrained firms when excessive use of internal funds is less costly and, therefore, preferable. In more objective research of Malmendier and Tate (2005) overconfident managers are those who persistently fail to reduce their personal exposure to company-specific risk, measured through the portfolio of holding in-money options. The result was a strong positive relation between the sensitivity of investment to cash flow and managerial overconfidence.

In other words, managerial optimism leads to investment distortions as investment projects become dependent on cash flow availability (Mohamed et al, 2014). Cash availability intends intensive investments - both reasonable and unreasonable, cash shortage results in rejecting profitable projects. Unconstrained firms with cash excess, correspondingly, may use their internal sources inefficiently and underinvest compared to their constrained peers who are forced to follow more conservative investment policy. As Chen and Lin (2013) postulate, optimistic CEOs in such firms do not worry about costly external funds and are ready to undertake risky projects with high expected returns while constrained firms have to cut their investments.

Thus, the first hypothesis implies:

H1: More overconfident CEOs tend to invest more than their less overconfident colleagues.

2 CEO overconfidence and board's role in investment decision-making

Top-management is not a single body involved in decision-making related to investments. According to agency theory board of directors is the main controlling and monitoring authority in the firm (Filatotchev, Wright, 2005; Ben-Amar, 2013; McCahery,Vermeulen, 2014) and, therefore, indirectly participates in strategic decision-making. The board is expected to keep managerial actions within prescribed boundaries preventing short-termism, opporunistic behavior and minimizing agency costs. In this framework board's active position in developing and implementing strategies is not a priority (Ben-Amar et al, 2013).

Within this agency-principal paradigm effective board of directors is seen as independent and isolated from executive bodies (Gordon, 2007; Brown et al, 2011; Masulis, Mobbs, 2011). Such boards may become beneficial for firm's performance when this firm has great investment options as Muniandy and Hillier (2015) prove in their research. They test moderating role of corporate governance independence in relationship between growth options and performance of 151 South African firms. The authors conclude that special conditions of developing market create favorable circumstances for synergy effect of investment opportunities and independent strength of the board on firm's profitability (Muniandy, Hillier, 2015).

Thus, board's monitoring performs like a filter which sifts inefficient and high risky investment projects accepting those that fit investment opportunities in the best way. Experience of US developed market shows that board independence is able to mitigate the problem of excessive investment by self-interested managers who tend to acquire some private benefits (Lu, Wang, 2014).When the firm possesses excessive amount of available cash their managers may have a tendency to invest heavily damaging shareholders' value. Surplus internal funds correlate closely to the potential investment opportunities that are perceived by overconfident managers as a great chance to invest because there is no necessity to bother about costly external financing (Chen, Lin, 2013). In this situation the board of directors with superior monitoring and controlling functions should prevent excessive investments that appear to be inefficient.

Besides, board's independence may be reflected through separation between firm's CEO and the Chairman of the board. Combining both positions and intending leadership duality gives CEO more power over the board in decisions-making processes that maximizes his or her own benefits but destroys firm's value (Lu, Wang, 2014). This violates the principle of division between executive functions and controlling (Bryan, Klein, 2004) that makes impossible to replace poorly performing CEO by the board (Goyal, Park, 2002). Consequently, if CEO tends to invest heavily then his or her duality worsens firm's performance in more pronounced degree than in the case of separation between his or her executive and control roles. Moreover, if CEO with dual functioning demonstrates overconfident behavior this may appear in the whole board's actions as their Chairman is able to impose or infect his/her biased decisions.

Thus, the second hypothesis states:

H2: Independent board of directors is able to prevent excessive investments leading by overconfident CEOs through their monitoring and controlling functions.

However, J. A. McCahery and E.P.M. Vermeulen (2014) postulate that strategic advice of board is missing among their monitoring functions and, therefore, construct one more dimension of corporate governance allowing to undertake strategy development resulting in growth of market-leading firm. The concept of strategic advice can be considered as addition to traditional view of board's role in firm's operating and assume that directors themselves can perform as initiators of strategic changes apart from examiners of ideas promoted by management team.

Bhagat and Black (2002) add to the concept of board's strategic initiative by discussing "insiders" in the board who are better informed and equipped with sufficient knowledge for strategic planning. Inside directors have greater firm-specific expertise and deeper understanding of firm's internal operating mechanisms (Muniandy, Hillier, 2015). Thus, corporate governance is designed to act not only along with the interests of shareholders but also to help management to overcome conservatism and to advise them on strategic issues (Lu, Wang, 2014). Besides, the board's role of strategic advisor requires from directors planning on long-term horizons (Bryan, Klein, 2004). When directors are of older age and come near retirement their planning horizons on investment strategies may shrink preventing their effective advising activity in favor of management team. Correspondingly, advising role of the board is closely connected with their age.

Thus, while risk-averse managers need incentives or encouraging arrangements to induce risk-taking decisions overconfident managers naturally undervalue risks and ready to undertake risky projects without any stimulus from the board. Therefore, the third hypothesis postulates:

H3: Overconfident CEOs do not need any incentives from the board of directors to make risk-taking investment decisions.



2. Empirical study

2.1 Methodology and model

For testing all three hypotheses multiple panel regressions are built. Model specification for the first hypothesis about relationship between CEO overconfidence and investment level in the company has the following form:

(1)

where is firm's capital investments normalized on lagged total assets, is index for CEO overconfidence (detailed description and construction procedure will be presented further in the next section). Control variables Detailed description and calculation of control variables are presented in Appendix 1 Table 1.: is firm's size expressed through its total assets and is assets tangibility, reflects firm's profitability, reflects firm's debt burden, is financial slack of the firm, is Tobin's Q ratio approximating firm's growth opportunities (Muniandy, Hillier, 2015). The equation also includes dummy variable for Utilities industry as it is regulated by governance and follows, therefore, less risky investment strategies. Dummies for each year (apart from 2009) are also included in order to consider time variability of operational and financial variables.

Financial slack and leverage control for internal funding as availability of internal funds serves as condition for investments (Heaton, 2002; Malmendier, Tate, 2005; Chen, Lin, 2013). The higher a level of firm's leverage more pressing the problem of debt overhang, less investment prospects and the greater agency costs of debt (Bryan, Klein, 2004; Chen, Lin, 2013; Muniandy, Hillier, 2015).

Model 1 tests the first hypothesis by estimating coefficient that is expected to be positive.

Verifying the second hypothesis about parallels between investments level in the companies under overconfident CEOs and monitoring functions of the boards supposes the following model:

(2)

where is dummy for firms who "underinvest" compared to other sample peers that means their high investment opportunities. These opportunities are expressed through sufficiency of internal funds and debt burden of the firm. When the company has surplus of cash there are free resources for investing and managers of these firms may have intension to make more investments including inefficient injections (Jensen, 1986; Opler et al, 1999; Stein, 2003; Bryan, Klein, 2004; Chen, Lin, 2013). At the same time low level of debt in the firm excludes debt overhang problems and diminishes bankruptcy risks that multiplies investment opportunities (Myers, 1977; Stein, 2003; Chen, Lin, 2013). For detecting firms with great investment opportunities procedure similar to that described by Chen and Lin (2013) is exploited. Two parameters - cash availability and firm's leverage are used to identify firm with high and low investment options. First of all, leverage is multiplied by -1 in order to receive the same direction of influence as cash. Then all the firms are ranked along with both parameters from the smallest to the largest values for each year (1 to 88 rank). The final ranking score for each firm is calculated as the average of two ranks by cash and leverage. Thus, there are five rankings (2009-2014) with composite scores and for each of them bottom 25% are considered as "underinvesting" that is with great investment opportunities due to excess cash and low leverage while top 25% are supposed to be "overinvesting" with cash deficit and debt overloading. Therefore, two dummies for great and poor investment opportunities appear.

Further, firms with great investment opportunities have heavier informational asymmetry that increases the probability of opportunistic behavior of managers (Bryan, Klein, 2014). It is the case when monitoring role of the board of directors is expected to mitigate these risks and lower agency costs. Correspondingly, and are proxies for monitoring role of the board for investment decisions (detailed description of board variables will be presented further in the next section). is variable for proportion of the board's outsiders who does not hold any position at this company and is not affiliated to it. Independent directors are supposed to perform monitoring functions in the better way as they do not depend on managerial influence and rely on outside expertise - external audit, for example (Bryan, Klein, 2014). reflects the separation between the board's Chairman and CEO positions. Division of executive and monitoring roles diminishes probability of potential overinvesting problem in the company.

Control variables in the proposed regression are the same as in the previous model (1).

Model 2 tests the second hypothesis by estimating and

coefficients that are expected to be significantly negative.

The regression for testing the third hypothesis about investment decisions driven by CEO overconfidence and board advising role has the following form:

(3)

where and are proxy indicators for advising role of the board on investment opportunities for CEO (detailed description of board variables will be presented further in the next section). is variable characterizing "degree of youth" of the board that is to what extent the average board's age is young. Older directors are expected to have shorter investment planning horizons as they come near their retirement. reflects the degree of the board's dependency, their affiliation to the company and involvement into its operations. Insiders are better familiar with current financial and operating situation in the firm and appear more competent in advising on strategic issues. Control variables in the proposed regression are the same as in the previous model (2).

Risk-averse managers need incentives to enter risky investment projects and wait for strategic advices from the board while overconfident managers underestimating risks undertake these projects easily. Thus, overconfident managers feel no necessity in the board's stimulus and encouragement. Model 3 tests the second hypothesis by estimating and coefficients that are expected to be non-significant.

2.2 Variables and CEO overconfidence index construction

Overconfidence of CEO will be approximated through their personal characteristics which determine their cognitive and emotional way of thinking that is sources of behavioral biases appearance. Existing ways of managerial overconfidence modeling are mostly expressed through managers' manipulations with the firm's stock options, their portraits in the press and media or their answers on special questionnaires. All these methods are rather complex and poorly connected with their personal cognitive characteristics which form predisposition to behavioral biases.

Moreover, managers' shareholding in Russia is not disclosed clearly and properly in firms' annual reports. As for media, it differs by its subjectivity and does not reflect managers' objective skills and experience.

In the research personal CEOs' characteristics are used - education and experience as proxies for overconfidence like in the research of Wei et al, 2011 carried on Chinese market as psychological studies suggest that behavioral biases can be affected by age, gender, education, working experience, skills and talents (Heath, Tversky, 1991). The following characteristics are used:

· CEO age. Older managers have more experience in certain areas, they may learn on their previous failures and mistakes (Forbes, 2005). Besides, they may accurately estimate their previous experience and correspond it with current knowledge decreasing the degree of predisposition to biased judging. Older managers seem to be less overconfident. On the other hand, Korniotis and Kumar (2011) postulate that older investors have poorer investment skills and, therefore, are tend to make irrational decisions, though experience may correct the potential bias (Menkhoff et al, 2013). However, Gloede and Menkhoff (2014) in their research statistically proves that age does not control for influence of experience on overconfident behavior, in other words, experience effect does not origin from getting older.

· CEO tenure. Experienced CEOs have more knowledge and competencies from their past decisions on his/her position and, therefore, are able to adjust potential biases in decision-making (Wei et al, 2012).

· CEO industry experience. When CEO earlier worked within the same industry where at the moment his company operates, he or she also feels that he has enough related knowledge to see into industry specific and make effective decisions. Thus, industry experience adds to managerial overconfidence. This is proved in the research of Mishra and Metilda (2015) where mutual funds investors with higher financial education and more extensive market experience feel more overconfident confirming the results received earlier by Deaves, Luders and Schroder (2010). On the other hand, Gloede, Menkhoff (2014) find out that financial experience of financial professionals is negatively correlated with overconfidence degree. It is positive learning effect that suppresses overconfident behavior as professionals are able to use information from experienced failures and successes in forming their rational expectations and making rational decisions (Gloede, Menkhoff, 2014). However, Gervais and Odean (2001) argue that learning effect starts to work only on the late stages of individual's career while growing experience on early phase is accompanied by development of overconfidence. Thus, relation between working experience and overconfidence is mixed and may change over time during career path.

· CEO industry related education background. Heath, Tversky (1991) postulate that people feel overconfident when they think they have more related knowledge in the area they are interested in or work within (Heath, Tversky, 1991). This finds confirmation in the empirical papers of Deaves, Luders and Schroder (2010) and Mishra and Metilda (2015) where stock market practitioners and mutual fund investors are analyzed. As for CEO, if he or she has education in the area where his current firm operates, he or she, probably, relies on all his/her necessary knowledge and competencies for accurate decision-making related to firm's industry specific. In this situation CEO may feel more overconfident.

· CEO multiple education background. On the other hand, if CEO has knowledge in many areas he may rely on his universal and multilateral competencies to be applied in judging. Thus, "multieducational" CEO is to be more overconfident.

· CEO duality. When CEO is of dual role as executive director and as chairman of the board he feels powerful and, consequently, has more discretion to influence decisions (Adams et al, 2005; Wei et al, 2012). This is like a kind of "combined leadership" of one person, particularly, CEO in the company (Krenn, 2014). This stimulates illusion of control not only over firm's issues but also over the board's decisions facilitating managers' overconfidence. Moreover, when the chairman of the board is also the CEO, the board makes managers accountable to an authority headed by management. This implies that CEO takes a position of assessing his or her own performance (Krenn, 2014).

· CEO entrepreneurship. Adams, Almeida and Ferreira (2005) propose that founder's status of managers make them think that they are powerful and influential in relation to the firms' decisions. Alongside with this viewpoint Barros and Silveria (2007) state the hypothesis that managers who have also the status of an entrepreneur that is who run their own business tend to be more optimistic and overconfident than non-entrepreneur colleges. Founders of their own businesses have hypertrophied feel of control and responsibility, moreover, self-employed individuals have a bias to overestimate the probability of success and also underestimate probable failure of the projects under their management (Barros, Silveria, 2007) and, therefore, they seem to be more overconfident.

Thus, influence of several personal characteristics given above on biased behavior is multidirectional and, therefore, mixed according to different authors. The necessity of combined indicators is obvious. For example, it is possible to construct the following proxies:

· CEO industry related education multiplied by industry related experience. There are arguments why having only industry related education or industry experience it is not sufficient for CEO. Knowledge received dozens of years ago may be overlapped by following additional education or simply be forgotten and not to be perceived by CEO as primary and sufficient to feel competent in the certain area. On the other hand, experience in the same industry may be not connected with management or production processes where industry specific does play important role, but with financial or marketing issues which are more universal across the industries. Only combination of industry related education followed by experience in the same industry does make managers realize their full competency in this field and, therefore, feel more overconfident that, in turn, cause overinvestment activity.

· CEO tenure multiplied by industry related experience. Positive learning effect as was shown earlier enters the process of correcting potential behavioral biases on the late stages of individual's career path. Thus, a manager needs to work on his position during a certain amount of years in order to receive benefits from his experience.

On the basis of this pull of CEO characteristics it is possible to construct CEO overconfidence index (Over_score) that could reflect the degree of overconfidence behavior. The procedure of building index for CEO overconfidence is following: for the quantitative variables the mean value is calculated and for observations where values of corresponding variables are higher that the mean "1" or "0" is assigned depending on the influence direction of each indicator. For binary variables the process is simpler: "1" values add to the index score and "0" do not change the index value. Therefore, the index score appears by summarizing "1" and "0" derived from both quantitative and binary variables for each firm-year. Extreme values of the index reflect high degree of CEO overconfidence and for the research sample this value is 4 while the minimum one is 0 and the mean equals to 1.17. Descriptive statistics for each variable involved into construction of this score are presented in Appendix 1 Table 2&3.

Table 3 demonstrates the description of the parameters included into CEO overconfidence score and their effect on degree of overconfident appearance.

Table 3. Description of variables for CEO overconfidence score

Variable	Type	Description	Add to/ diminish overconfidence degree
age	Quantitative	CEO's age	Increase in age lowers degree of overconfidence
duality	Binary	Dual role of CEO: equals to 1 if CEO is the chairman of the board, 0 otherwise	Having dual role adds to degree of overconfidence
founder	Binary	Entrepreneurship role of CEO: equals to 1 if CEO is one of the firm's founders, 0 otherwise	Having status of firm's founder adds to degree of overconfidence
industry experience* tenure+	Binary* Quantitative	Positive learning effect on condition that CEO has industry experience (Gloede, Menkhoff, 2014): equals to number of years during which CEO is holding its position in the firm if CEO has industry experience, 0 otherwise	Increase in tenure provided having industry experience lowers degree of overconfidence
multiple education	Binary	Educational diversity of CEO: equals 1 if CEO has more than one education, 0 otherwise	Having multiple education adds to degree of overconfidence
industry related education++* industry experience+++	Binary* Binary	CEO's industry related education followed by experience in the same industry: equals to 1 if CEO has both industry related education and experience, 0 otherwise ...

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