Managerial optimism: New observations on the unifying theory

• Published date: 01 November 2019
• Date: 01 November 2019
• DOI: http://doi.org/10.1111/eufm.12218

© 2019 The Authors. European Financial Management Published by John Wiley & Sons Ltd.

Eur Financ Manag. 2019;25:1150–1167.1150

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wileyonlinelibrary.com/journal/eufm

DOI: 10.1111/eufm.12218

ORIGINAL ARTICLE

Managerial optimism: New observations on

the unifying theory

J. B. Heaton

J.B. Heaton, P.C., Chicago, Illinois

Correspondence

J. B. Heaton, 20 West Kinzie Street

17th Floor, Chicago IL 60654, USA

(312) 487‐2600.

Email: jb@jbheaton.com

Abstract

Managerial optimism theory is behavioral finance’s great-

est achievement. It explains two prominent features of

corporate financial behavior –over‐investment and peck-

ing‐order capital structure preferences –that otherwise

require two different theories with mutually incompatible

assumptions about managerial loyalties to shareholder‐

value maximization. After reviewing the development of

managerial optimism as a unifying theory, I use a simple

change of measure to transform risk‐averse optimism to

risk‐neutral probabilities that can be pessimistic or

optimistic depending on wealth changes. This unexplored

feature has implications for, among other things, pay for

performance when managers are excessively optimistic.

KEYWORDS

agency cost theory, asymmetric information theory, behavioral

corporate finance, managerial optimism, pay for performance

JEL CLASSIFICATION

G30; G31; G32; G34

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INTRODUCTION

A unifying theory accounts for empirical phenomena that otherwise require multiple theories

(Myrvold, 2003). It is most attractive when the theories it unifies make “mutually incompatible

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

We are very grateful to the editor, John Doukas, and an anonymous referee for insightful comments on earlier drafts

which have helped to improve the quality of the paper.

assumptions about the system”under study (Rueger, 2005, p. 579). Managerial optimism is a

unifying theory of corporate finance.

Managerial optimism theory, starting with Heaton (2002) and Malmendier and Tate

(2005a, 2005b), accounts for two prominent features of corporate financial behavior (over‐

investment and pecking‐order capital structure preferences) that otherwise require two different

theories (agency cost theory and asymmetric information theory). Moreover, those two theories

make mutually incompatible assumptions about managerial loyalties to shareholder‐value

maximization: disloyal managers in agency cost theory and loyal managers in asymmetric

information theory. Managerial optimism also has proven to be a more parsimonious theory than

those alternative theories, one that delivers predictions with far simpler models. The assumptions of

managerial optimism theory also rest on better empirical evidence: a well‐established psychological

bias found in numerous experiments rather than merely conjectured (but unobservable) agency

costs and information asymmetries.

In this paper I explore the development of managerial optimism as a unifying theory from its

antecedents in agency cost theory and asymmetric information theory. Agency cost theory and

asymmetric information theory continue as active research paradigms. I suggest three reasons

for their survival. First, researchers sometimes seek to study a problem that actually requires

those assumptions, though I believe this is a minor reason for the survival of these theories.

Second, there is a continuing resistance to behavioral approaches in some quarters due to the

failure of behavioral finance to advance very much our understanding of asset pricing. Third,

and probably most important, academic corporate finance, like every field, suffers a form of

path dependence where there is little urgency to abandon old theories that have already enjoyed

acceptance and can explain the observed facts whether or not the theories are inconsistent and

without good support for their assumptions.

In the second part of the paper, I propose that researchers focus on an unexplored but intriguing

interaction of optimism and risk aversion. I develop this interaction in a simple change‐of‐measure

approach. The interaction of optimism and risk aversion provides a parsimonious explanation for

behavior –risk‐averse purchase of unfairly priced insurance and risk‐seeking purchase of unfairly

priced lottery tickets –that has previously been attributed to Friedman–Savage utility functions

(Friedman & Savage, 1948) or, most commonly, prospect theory preferences (Kahneman & Tversky,

1979). I show that simultaneous risk aversion and risk seeking arise naturally in an expected‐utility

framework with concave utility functions and optimistic beliefs. I explore this feature of optimism for

managerial decision‐making and pay for performance when managers are excessively optimistic.

Section 2 explores the antecedents of managerial optimism theory: agency cost theory and

asymmetric information theory. Section 3 describes the development of managerial optimism

theory. Section 4 discusses the survival of agency cost theory and asymmetric information theory in

light of the superiority of managerial optimism theory. Section 5 develops insights into risk‐averse

optimism with an emphasis on implications for pay for performance. Section 6 concludes.

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ANTECEDENTS

Managerial optimism unifies two different theories of corporate finance: agency cost theory and

asymmetric information theory.

2.1

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Agency cost theory

Agency cost theory evolved from early objections to the profit‐maximization assumption of

neoclassical economics. Several economists, most notably Oliver Williamson (1963), asserted

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