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How to Make Better Decisions?

Lessons Learned from
Behavioral Corporate







managers and investors and its impacts on firm value.
Traditional theory supposes that both groups act rationally.
If this was true, managers could assume efficient financial
markets. This means that stocks and bonds would be fairly
priced in every single moment.

In reality, however, rational behavior cannot be assumed for
either managers or investors.
Instead, Behavioral Corporate Finance : Several psychological
biases influence decision making of both groups.

Two types of research studies:

The first approach:
Irrational behavior of managers in the context of efficient
financial markets.

The second approach:
Investors are systematically irrational but managers are
rational and well-informed.

Many empirical studies discover
managerial behavior that is systematic.


overconfident and excessively optimistic (BenDavid, Graham & Harvey, 2010).
Anchoring, mental accounting and bounded
rationality (Baker, Ruback & Wurgler, 2004;
Gervais, 2010).

Excessive optimism The frequency of favorable outcomes is overestimated. Bounded rationality Decisions are not rational because individuals have incomplete information. Definition of biases (see also Shefrin. Mental accounting Deciding based on different mental accounts. . Anchoring People anchor on an unimportant number and adjust insufficiently.Table 1. 2007) Definition Overconfidence Individuals believe that they are better than they really are.

.The irrational investor approach assumes that managers possess an informational advantage over investors.

• Muelbroek (1992) studies illegal insider trading and also finds that managers earn higher returns than the market. 2012). .Seyhun (1992) confirms that managers are well-informed: • He shows that they outperform the market with legal insider trading (Baker & Wurgler.

.Irrational Managers and Efficient Markets Considering managerial decisions to the disadvantage of shareholders. the literature distinguishes between intentional and unintentional (psychological reasons) value reducing decisions.


Psychological Barriers to Arm’s Length Contracting • Jensen and Meckling model assumes that the independent non-executive directors deal with the senior management team at arm’s length. • Examining the explosion of executive compensation. Reasons: . often in response to mediocre performance. Bebchuk and Fried (2004) have concluded this ‘arm’s length contracting ‘ model of corporate governance is largely fictional.

‘cognitive dissonance’ . avoiding anything that goes against your patron is highly probable. So.  CEOs are rather forceful people. the big pay-packets and severance terms they received will be questioned if they raise the same questions for the companies in whose board they are now. confronting them could be bruising and retaliation is expected. is on the board of AAA Co.  Loyalty – Often the CEO nominates or has a veto over potential new independent directors. and the CEO of BBB Co. Many non-executive directors are retired successful CEOs of the company itself or companies in the same sector.  Most of us like to think that we do a pretty good job and shun evidence that suggests otherwise. is on the board of BBB Co. . So. Interlocking directorships – CEO of AAA Co. So.

Group Psychology on the Board. Building Consensus and its Dissimulation • The centrality of group decision making: Peer pressure and interpersonal conflict The impact of Board representation and composition on corporate performance .

which appointed them. .• Clearing out the ‘Inside view’ • The inside view fixation can be ameliorated by an opposing outside view. • But often too quickly they adopt the ‘inside view’. not wishing to be obstructive to incumbent management. This suggests a clear role for non-executive directors.

Hawthrone plant of Western Electric company. . • Inclusion in the elite group such as the board of directors of a blue chip company is something most would value and be reluctant to surrender once received. • It is nice to be noticed.THE SATISFACTION OF RECOGNITION .

.Financing Decisions Heaton (2002):There is a relationship between excessive optimism and the pecking order theory that influences the capital structure. According to Heaton (2002). excessive optimism leads managers to assume that their own companies are undervalued.

He attributes this finding to overconfidence. It explains the reluctance to issue new shares and the preference for internal financing. .Graham (1999) : Questionnaire survey: Majority of managers are convinced that their companies are undervalued although the survey took place during the Internet Boom at the end of the last century.

Overconfidence. measured by the frequency executives appear in the public. is positively related to the number of takeovers. .Investment Decisions Roll (1986): Overconfidence leads to fostering takeovers.

.• Porter and Singh (2010): Managers overestimate synergies and underestimate costs associated with acquisitions.

Landier and Thesmar (2009): A survey of managers of young firms  Majority have the outlook for future development of the firm will be positive. .  Three years later. already 17 percent of survey participants expect future difficulties.  Only 6 percent of the surveyed managers expect difficulties. the managers evaluate the situation more realistically: Now.

Cost-estimations of large-scale projects: Over optimistic  In retrospect costs are usually higher than initially expected. in contrast. are typically lower than originally expected.  Both effects lead to the acceptance of unfavorable projects due to excessive optimism.  Revenues. .

Malmendier and Tate (2005): Compare the stock market development of firms run by awarded managers with a control group and discover underperformance. . Reason:  Awarded managers are typically concerned with tasks (writing books. amongst others) that detract them from more important duties.  Another interpretation of the result is that winning awards increases overconfidence.

the mentioned simplification results in suboptimal investment choices. Thus. (bounded rationality) . questionnaire survey: fewer than 10 percent use different discount rates for different projects.Most managers use a single discount rate for all projects within the firm. A single discount rate: favors high-risk projects discriminates low-risk projects.

. 2007).  Managers hold on to less successful projects even if those projects should be finished under rational criteria (Fairchild. Prospect theory assumes that individuals are risk averse in the positive and risk seeking in the negative domain. 1979). individuals tend to opt for the gamble (Kahneman & Tversky.  between a gamble and a sure loss.

This phenomenon explains why the stock market reaction to finishing announcements of loss-making projects is on average positive (Statman & Sepe. . 1989. Baker.Hoping to break even. 2004). Ruback & Wurgler. managers typically throw good money after bad.

Irrational Investors and Rational Managers .

Rational managers balance between three goals. namely market timing. . catering and increasing intrinsic value (see Figure 2).

. for example by issuing overvalued or repurchasing undervalued shares.• Market timing relates to decisions that aim at exploiting temporary mispricing. • Increasing intrinsic value is self-explanatory. • Catering refers to decisions that aim at boosting stock prices above the level of intrinsic value.


particularly if they are overvalued.Financing Decisions The fact that new issues underperform in the long run spurs speculations that managers tend to issue stocks. .

Lakonishok and Vermaelen (2000): IPOs as well as SEOs have lower stock returns than the aggregate market. Issuing overvalued stocks lowers capital cost at the expense of new investors.Loughran and Ritter (1997) Ikenberry. .

Loughran. Ritter and Rydqvist (1994) : Number of IPOs is particularly high in times when valuation ratios indicate that the market is overvalued. .

These findings indicate that managers possess an information advantage over investors and issue new stocks if they are overvalued. .

.In summary. investors should be skeptical towards new issues for at least two reasons:  First. newly issued shares underperform compared to the aggregate market. newly issued shares are typically issued when the aggregate market or the industry is at a high or at an interim high.  Secondly.

Harvey and Michaely (2005):  Managers say that they consider undervaluation indeed as an important criterion for repurchases.Repurchases: Asked by Brav. Graham. .

Investment Decisions Shleifer and Vishny (2003) develop a theory for corporate takeovers. in contrast.  Undervalued firms. . Firms undertake acquisitions if their own stocks are an attractive currency to finance the purchase  Overvalued firms gain if they pay with own shares. should prefer to pay in cash.

And therein lays opportunity for investment managers and firms.A reason for stock acquisition: Individual and even institutional investors often give in to inertia and hold on to shares in unwanted stock. .

So when another company uses stock to acquire a firm in which you hold a stake. what do you do with the new shares you suddenly own of a company that you never intended to buy in the first place? .

Stein: 80 percent of individual investors and 30 percent of institutional investors appear to be more inertial than logical. passively accepting the shares offered as consideration in stock mergers and acquisitions. Jeremy C. They take the default option. .Logic suggests that you would be likely to sell those shares.

and debt can only be used to finance one of the two transactions. how should the remaining $100 of equity be issued? . If the target and the factory each cost $100.A hypothetical company with a fixed strategy that involves • acquiring another company • and building a new factory.

because supply of shares in the market is constrained.If shareholders in the target are inertial. and borrow money to build the factory. . it is more cost-effective to raise equity in the context of a merger.

.Recommendations for Managers and Investors The assumption of rational behavior is not realistic. managers and investors make mistakes. Instead.

Of course. Debiasing is difficult because the psychology that forms the basis of those mistakes is very robust. . individuals are able to learn about biases but learning takes very long.The question is how to prevent them.

If feedback comes in fast and is clear. it is easier to realize mistakes than if feedback comes in slow and is ambiguous. . Moreover the complexity varies from situation to situation. In the selection of managers. debiasing needs time and effort. investors should not only consider managerial actions but also the motives behind the actions.Therefore.

 Managers frequently repurchase shares in order to increase demand for price stabilization reasons.  Investors should be skeptical towards management that in the past frequently engaged in takeovers that proved to be value destroying in retrospect. .

An annual report: Berkshire Hathaway provides a good example how loyal investors can learn from management.If capable managers encounter uninformed investors. . managers can try to give investors an understanding of value oriented management. Instead they are treated as long-term partners. shareholders are not considered faceless figures in an ever shifting crowd. Here.

time and effort to familiarize investors with value increasing business principles pay off for the management. .In this case.

. However.Executives should confine themselves to value oriented management. informed investors are needed to provide incentives that ensure that not earnings manipulation but value increasing actions pay off for managers. This would render earnings management and other accounting manipulating actions unnecessary.

Conclusion Research in the field of Behavioral Corporate Finance shows that managers as well as investors act irrationally – at least partly. .