1. Introduction
CEOs, like all people, have limited rationality, so they do not always make optimal decisions. Overconfidence is most robust in psychological biases and has been used to explain executives’ suboptimal decision-making [
1]. Prior research demonstrates a link between managerial overconfidence and corporate policies [
2,
3,
4,
5,
6,
7]. However, little is known about how managerial overconfidence impacts corporate social responsibility (CSR) activities. We investigated the relationship between managerial overconfidence and CSR activities using a textual analysis of 10-K reports from the US Securities and Exchange Commission (SEC) EDGAR database.
Recently, many studies on CSR have covered the relationship between CSR and financial performance. A number of empirical studies have shown that the more CSR activities a company is involved in, the better its long-term performance (e.g., [
8,
9]). Li et al. [
10] investigated equity returns and showed that a portfolio consisting of the best CSR companies in the world generated positive abnormal returns. On the other hand, the relationship between CSR and financial performance could be negative, because CSR expenditures cause additional costs for firms and divert funds from more profitable potential investments. This negative relationship was also confirmed by a number of empirical studies (e.g., [
11,
12,
13]).
In this paper, we focus on the impact of a CEO’s overconfidence on decisions regarding a company’s CSR activities. Since overconfident CEOs are likely to consider CSR activities less important than their own managing ability, they tend to reduce CSR activities. Also, overconfident CEOs may overlook CSR activities because of optimistic expectations of their future performance.
CSR activities are diverse and mostly require financial resources, which include community engagement, marketing and advertising, customer relations, workplace health and safety, union relations, human rights policies, product safety and quality, transparency in reporting, governance structure, and environmental protection activities. Chan et al. [
14] found that, in general, firms facing financial constraints do not engage in any CSR activities. Zhao and Xiao [
15] also found that CSR engagement is negatively correlated with financial constraints. Therefore, if firms face financial constraints with regard to engaging in CSR activities, rigorous CSR activities could be harmful to their long-term performance. We examine the long-term performance of CSR activities initiated by overconfident CEOs, considering financial constraints.
Prior research on the impact of a CEO’s emotional bias (optimism, loss aversion, overconfidence) and other self-serving bias on corporate strategic decisions included financing decision [
16], investments [
17], dividend payment [
18], cost behavior, and R&D expenditure [
19]. This paper tries to examine the impact of CEOs’ overconfidence level on CSR activities for the first time. As far as we know, no previous research has investigated the relationships between managerial overconfidence, CSR activities, and financial performance. This research offers a particular qualitative approach in providing a new measurement of CEO overconfidence through computer-assisted textual analysis, by describing and interpreting characteristics of the management discussion and analysis (MD&A). Classified as overconfident or normal, CEOs prefer to choose more or fewer CSR activities, according to their characteristics. The long-term performance of a firm depends on its CSR activities as well as its financial situation. Specifically, if a firm is financially unconstrained, then fewer CSR activities initiated by an overconfident CEO would result in a negative long-term performance. However, if a firm is constrained, choosing fewer CSR activities would be a better policy.
We employ a sample of 19,367 observations of US firms from 1994 to 2016, and the empirical implications of our study are as follows. First, CEO overconfidence appears to lead to fewer CSR activities. Our results indicate that the level of CSR activities is lower in firms managed by overconfident CEOs. Also, CEO overconfidence is related to less CSR strength and more CSR concerns. Additionally, CSR activities lead to positive long-term performance in firms with financial slack. These outcomes are robust in a subsample of financially unconstrained firms with overconfident CEOs.
We contribute to the growing literature on the impact of CEO overconfidence on corporate decisions by offering the first evidence of a relationship between CEO overconfidence and firms’ CSR activities. Also, we expand the scope of CSR study by considering the influence of financial constraints and exploring the relationship between overconfident CEOs and their preferred level of CSR activities. Recent evidence indicates that managerial overconfidence can lead to decisions that harm firm value. Our results support this notion, as we find that highly overconfident managers are associated with negative long-term performance when firms are financially unconstrained.
This paper is organized as follows:
Section 2 contains a short literature review regarding CEO overconfidence, CSR activities, and long-term performance, and
Section 3 presents the research hypotheses and describes the research methodology.
Section 4 presents the main findings of our study, and
Section 5 concludes and gives some future research ideas.
2. Literature Review
Overconfidence is generally explained as a phenomenon in which one overestimates the accuracy of one’s judgments [
20]. According to Moore and Healy [
21], there are three types of overconfidence. The first type is overestimation, which occurs when a person has overestimated the degree of their abilities, performance, control, or probability of success. The second type is overplacement, which occurs when someone believes that they are better than someone else. This attribute has been described as the better-than-average effect. The third type is overprecision, which is when someone believes that their belief is more precise than it is. Duttle [
1] stated that overestimation and overplacement are based on performance, while overprecision is based on calibration. Most psychological studies on overconfidence are based on overestimation and overplacement. Hilton et al. [
22] also stated that there are three types of overconfidence: judgment overconfidence, self-enhancement bias, and social risk-related optimism. Overplacement, including the better-than-average effect, is a type of self-enhancement bias. Regardless of the actual model used, researchers have found that there is a variety of types of overconfidence.
The literature regarding CEO overconfidence essentially stems from the notion of a “better-than-average” effect in the psychology literature [
23,
24,
25]. The better-than-average notion is also applied to future events for which people express unrealistic optimism [
26]. Studies about human irrationality have been conducted not only about investors, but also about company managers. The psychological biases of company managers have a significant influence on companies’ decision-making processes [
27,
28]. Roll [
29] introduced the concept of CEO overconfidence through his hypothesis of managerial hubris, the first of its kind in academic finance. Overconfidence may impair moral awareness and result in unethical behavior. Thus, fraud, accounting, and financial scandals, and other adverse outcomes, are some of the consequences of overconfidence documented in the literature [
3,
30,
31,
32].
Regarding the theoretical background on managerial overconfidence, Azouzi and Jarboui [
16] explained that the main cause of capital structure choice is CEO emotional bias (optimism, loss aversion, and overconfidence). They showed that CEOs (optimistic, loss averse, and overconfident) prefer to finance their projects primarily through internal capital, secondly by debt, and finally by equity, which implies the presence of a pecking order of choice. Based on prior studies, Chen et al. [
33] argued that the greater the CEO’s overconfidence, the higher the expectations for future performance, which results in asymmetric cost behavior. Hur et al. [
20] examined the impact of a CEO’s confidence level on decisions regarding research and development (R&D) expenditures.
One of the most important issues in the study of overconfidence is how to measure it. Psychology studies commonly measure overconfidence through surveys. However, most finance studies use proxy variables, such as a company’s financial information, when measuring levels of CEO overconfidence. Despite the development of various methods, optimism and categories of overconfidence have been confusingly used when it comes to the concept of overconfidence [
34,
35]. Malmendier and Tate [
2] defined optimism as overconfidence and modeled overconfident CEOs as overestimating future firm performance. Although no consensus has been reached on measuring overconfidence, there has been a lot of research classifying overconfidence in terms of a high level of “optimism” (e.g., [
36]).
For empirical studies, the methods of measuring overconfidence variables can largely be divided into stock option-based and text analysis. Using ExecuComp data, Campbell et al. [
4] defined highly optimistic CEOs, which is a stock option-based measurement. Text analysis, meanwhile, analyzes the content of a firm’s nonfinancial documents to extract meaningful information.
Malmendier and Tate [
2,
3] were the first to provide a way to measure overconfidence using stock options. They saw that risk-averse executives tended to exercise stock options before overconfident executives did, because the latter believed that the stock was undervalued. Since they introduced this method, many studies have used 67% or 100% standards of average stock option prices to measure overconfidence [
8,
37].
Textual analysis measures the tone of the content expressed in public disclosure, such as profit announcements [
38,
39], conference calls [
40], and 10-K reports. Loughran and McDonald [
41] developed a list of words in the financial context by analyzing the words used in 10-K documents submitted by US-listed companies, because they hypothesized that a specific dictionary in this context would have greater explanatory power than a general dictionary. However, in this case, the disadvantage is that fewer words are categorized. We applied Diction software for a text analysis, which is frequently used in many studies (e.g., [
42]), after Loughran and McDonald [
41].
Previous studies in the CSR literature have shown that CSR activities have a positive effect on financial performance and corporate value, because CSR raises the company’s reputation, leads to increased profitability, and improves employee productivity. CSR activities can enhance a company’s reputation and therefore improve its financial performance in the long run [
43]. In addition, through CSR, communication with various stakeholders has a positive impact on nonfinancial value and increases the value of the company in the long-term [
44,
45]. CSR activities are sometimes claimed to increase the value of intangible assets, such as brand value. However, some studies have shown that CSR has an adverse effect on corporate value, because it imposes additional costs on companies [
12,
46]. Zhao and Xiao [
15] examined the role of a firm’s life cycle stage on the relationship between CSR and financial constraints. They found that for firms in the growth, maturing, and declining phases of the life cycle, CSR engagement is negatively correlated with financial constraints. However, when researching information on CSR disclosure, Michelon et al. [
47] pointed to an increasing lack of completeness and decreasing amount of credibility in the information reported, as well as concerns about overall reporting practices.
Recently, many studies on CSR activities have focused on corporate identity and value. For example, empathetic leadership, embedded in a culture of justice and care, could establish norms and expectations that serve as guidelines for responsible management. Deliu [
48] argued that empathetic leadership entails effective corporate governance, and that companies have to grow emotional capital to handle issues of low morale, organizational stress, high staff turnover, and lack of work/life balance. Thus, corporate social responsibility (CSR) values cannot be communicated efficiently if they do not naturally belong to a company’s identity [
49]. Most studies on CSR have suggested that CSR activities improve a firm’s reputation. As a result, they lead to employees being gratified to work in their firm. Additionally, social identity theory would suggest that if treating others well is part of an employee’s self-concept, then they would find greater identification with an organization that treats others well [
50]. Kim et al. [
51] posited that due to the interpersonal nature of CSR, humans find meaningfulness through helping and improving the well-being of others. CSR contributes to the development of a favorable company image, enabling the firm to secure critical resources, enhance product competitiveness, and boost employee productivity [
52]. Tang et al. [
53] explored the role of the CSR engagement strategy. They proposed that firm profits are shaped by how firms engage in CSR and found that firms benefit more when they adopt a CSR engagement strategy that is consistent, involves related dimensions of CSR, and begins with aspects of CSR that are more internal to the firm.
Jo and Harjoto [
54] investigated the relationship between CSR, corporate governance, and corporate financial performance in a sample of 2952 US firms for the period 1993–2004. Their results showed that CSR resulting from effective corporate governance indicators, such as board independence, presence of institutional investors, and number of analysts following a firm, positively influences corporate financial performance. Using the same sample, in another study, the authors investigated the impact of governance and monitoring mechanisms on the financial performance of firms that engaged in CSR activities. The study found that the number of analysts following these indicators was positively related to firm value for CSR firms. Board leadership, board independence, blockholder ownership, and institutional ownership were also found to have a positive, but weaker, impact.
5. Conclusions
This paper empirically tested how CSR activities in firms with overconfident CEOs are related to the firms’ long-term performance, as measured by monthly abnormal returns using the Fama–French three-factor model. The results show that CSR activities are negatively related to long-term performance. However, when we considered CSR activities of firms with overconfident CEOs, the negative relationship between CSR and long-term performance disappeared. In some cases, CSR and AAR_12 showed a positive relationship. Another important finding of this paper is a positive relationship between financially constrained firms and their CSR activities. The results also show that increased CSR activities in the face of capital constraints are positively related to long-term performance. This result indicates that overconfident CEOs evaluate the impact of CSR less accurately than rational CEOs, reducing long-term performance, especially when there are financial constraints.
The results of this study have the following implications and contributions. First, the results empirically verify that CEO characteristics are related to CSR activities. The results also show that there are other factors related to CSR activities. Second, this study verified the long-term performance of CSR activities initiated by overconfident CEOs. In addition, overconfidence was measured through textual analysis of executives’ narratives as they appeared in official announcement documents. This methodology can expand the scope of analyzed companies, because it can be applied to all businesses that make public announcements. Finally, this study showed that the CSR of financially constrained firms is positively related to long-term performance, although CSR initiated by overconfident executives is negatively related to long-term performance. Depending on management characteristics, the scale of CSR activities may vary. The results of this study will have many research implications for CSR activities, CEO overconfidence, and financial constraints.
Overall, the results of this study were able to improve our understanding of CSR decisions by overconfident managers in firms with limited financial resources. However, the study suffered from the following limitations. First, the study employed the measure of optimism as a proxy for managerial overconfidence. Thus, the results lacked control for macro-economic and systematic factors, such as market sentiment, cost of capital, and regulation or institutional change, that might affect the CEOs’ self-confidence. Moreover, the study included only firms with CSR variables in the KLD dataset and results could be different if we extended the CSR variables to other activities, such as R&D, training and education, and advertising expenses. Future studies might deal with these limitations by using alternative variables with broader samples. Additionally, the other characteristics in corporate governance, such as executive compensation, stakeholder relations, family ownership ratio, or board structure, could be analyzed for future research.