Investor Overconfidence, Firm Valuation, and Corporate Decisions

Behavioral theory predicts that investor overconfidence leads to overpricing because overconfident investors overestimate the quality of their information and underestimate risk. We test this prediction by using a measure of investor overconfidence derived from the characteristics and holdings of U.S. equity mutual fund managers. We find that firms with more overconfident investors are relatively overvalued based on the market-to-book ratio and a misvaluation measure. The result is stronger among stocks with greater mutual fund ownership, particularly by active mutual funds. Firms with more overconfident investors also exhibit lower subsequent stock returns, issue more equity, and invest more. Overall, our findings suggest that investor overconfidence is significantly related to firm valuation and corporate decisions.