Overconfidence in Money Management: Balancing the Benefits and Costs   (PDF)

Individuals are overconfident, especially those in positions to influence outcomes. Overconfidence on the part of portfolio managers, can have severe consequences given the size of holdings of financial institutions. The impact of hiring an overconfident manager is studied here within the standard principal‐agent framework. When compensation is endogenously determined, I find that investors can benefit from managerial overconfidence. Overconfidence induces a higher level of effort until the effects of restrictions on portfolio formation take over. Further, by increasing the incentive fee and sharing more risk the investor can curb excessive risk taking. However, excessive overconfidence is detrimental to the investor.