Behavioral Corporate Finance

Here one more interesting paper on Behavioral Corp Finance. Do managers always make rational decisions? Does group decision making have an amplification effect on irrational decision making?

Highly recommended!

Excerpt:

There are two key behavioral impediments to the process of value maximization, one internal to the firm and the other external. I call the first impediment behavioral costs. Behavioral costs tend to undermine value creation. They are the costs—or, alternatively, the loss in value—associated with errors that managers make because of cognitive imperfections and emotional influences. The second impediment stems from
behavioral errors by analysts and investors. These errors can create a wedge between fundamental values and market prices. Managers may then find themselves unsure of how to factor the errors of analysts and investors into their own decision-making.1

Consider first the behavioral obstacles to value creation that are internal to the firm. At present, academics and practitioners involved in issues of value-based management tend to focus exclusively on agency costs, which arise when the interests of agents (in this case, managers) are in conflict with the interests of the principals they have been engaged to serve (the owners or stockholders). Mechanisms that encourage agents to act in accordance with principals’ interests are said to be incentive compatible.

Proponents of value-based management emphasize that with properly designed incentives, managers will maximize the value of the firms for which they work. But behavioral costs can be quite large, and cannot be addressed though incentives alone. This is not to say that incentives are immaterial—on the contrary, incentives are of critical importance. The point, however, is that there are limits to what incentives can achieve. If employees have a distorted view of what is in their own self-interest, or if they have a mistaken view of what actions they need to take in order to maximize their self-interest, then incentive compatibility, although necessary for value maximization, will not be sufficient.

Now consider the behavioral obstacles to value creation that are external to the firm. Proponents of behavioral finance argue that risk is not priced in accordance with the CAPM and that market prices often deviate from fundamental values.
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The literature in behavioral decision-making suggests that people tend to be:
• loss averse;
• susceptible to framing or packaging that leads them to select inferior options;
• overconfident; and
• prone to confirmation bias.