A tale of two biases: Unpacking the relationship of overestimation and overprecision on firm performance

Abstract Research Summary Overconfidence is widely known to influence firm decision‐making. Yet there remains confusion regarding the concept because it comprises three key aspects: overplacement, overestimation, and overprecision. Using archival data, we employ a firm‐level overconfidence construct to simultaneously analyze the impacts of both overestimation and overprecision. Based on proxies derived from management earnings guidance, overestimation has a sizeable, negative impact on firm performance that is uncorrelated with overprecision's sizeable, positive impact. The result that emerges is surprisingly large: more than one third of a firm's asset value can be explained by these combined facets of overconfidence. Managerial Summary Overconfidence is well known to executives. It mostly has a bad reputation, but the magnitude of its impact on a firm's strategic decision making is not well known. One aspect of overconfidence is overestimation, which leads to poor forecasts. This leads executives to exaggerate M&A synergies and underestimate the costs as well as the time to complete large capital projects, among other decisions. There is another facet to overconfidence: precision. Overconfidence leads to greater precision in forecasts. In this study, we use corporate earnings guidance. Overprecision in such guidance correlates positively with firm performance. We attribute this result to better investment decisions. We find the combined impact of the positive and negative aspects of overconfidence explains more than a third of a firm's asset value.