Chapter One

Behavioral Foundations

OVERVIEW
Chapter 1 introduces students to 10 key psychological phenomena that serve as
foundation concepts for the behavioral approach to corporate finance. The chapter begins
with a short summary of the traditional approach to corporate financial decisions,
emphasizing risk, value maximization, and agency conflicts. The remainder of the
chapter introduces the ten psychological phenomena through a series of examples that
illustrate how these phenomena can affect the decisions managers make, the risks they
take, and the impact on the values of their firms. These 10 phenomena are organized into
the following three groups:
1. biases (4)
2. heuristics (4)
3. framing effects (2)

Biases and heuristics are introduced using examples taken from the experiences of
the firm Sun Microsystems, notably its chief executive officer Scott McNealy. Framing
effects are introduced using examples taken from the experiences of the firm Merck &
Co. Thematic boxes called Behavioral Pitfalls boxes provide the relevant background
data for each firm.

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LEARNING OBJECTIVES
The main objective of the chapter is for students to demonstrate that they can
identify the 10 psychological phenomena that cause corporate managers to commit
expensive mistakes when making decisions. The three specific learning objectives for the
chapter are that students be able to:
1. Identify the key biases that lead managers to make faulty financial
decisions about risky alternatives.
2. Explain why reliance on heuristics and susceptibility to framing effects
render managers vulnerable to making faulty decisions that reduce firm
value.
3. Recognize that investors are susceptible to the same biases as managers,
and that mispricing stemming from investor errors can cause managers to
make faulty decisions that reduce firm value.

The chapter questions and mini-case appearing at the end of the chapter provide
the primary vehicles for testing whether students have met the learning objectives.

CHAPTER OUTLINE
Traditional Treatment of Corporate Financial Decisions
Financial managers are called upon to make several types of decisions about
sources and uses of funds in their firms. In theory, managers represent the interests of
shareholders and make value maximizing decisions. However, managers might have

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different interests than shareholders, with the resulting conflicts of interest being known
as agency conflicts.

Behavioral Treatment of Corporate Financial Decisions

Psychological phenomena often generate obstacles that interfere with managers
abilities to make value maximizing decisions. Because psychologically induced mistakes
can be, and often are, very expensive, studying behavioral corporate finance is vital.
Remedies required to address behavioral phenomena are typically different from the
incentive-based remedies required to address agency conflicts.

Illustrative Example
A series of articles that appeared in the publication BusinessWeek apply a series of
adjectives to Scott McNealy, the chief executive officer of Sun Microsystems. These
adjectives correspond to some of the main psychological traits that are part of the
behavioral approach. The discussion about McNealy provides a concrete example to
describe how particular traits affect the decisions managers make and the attendant
consequences of those decisions for value.

Biases
Biases represent the predisposition to commit specific types of errors. This section
describes 4 biases. Excessive optimism occurs when people overestimate how frequently
they will experience favorable outcomes, and underestimate how frequently they will

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experience unfavorable outcomes. Overconfidence occurs when people make mistakes

more frequently than they believe and view themselves as better than average.
Confirmation bias occurs when people attach too much importance to information that
supports their views relative to information that runs counter to their views. Illusion of
control occurs when people overestimate the extent to which they can control events.

Heuristics
A heuristic is a rule of thumb used to make a decision. Proponents of behavioral
finance suggest that people who rely on heuristics leave themselves vulnerable to specific
biases. The section describes 4 heuristics, or principles that underlie heuristics. People
who rely on representativeness use stereotypic thinking to make judgments. People who
rely on information that is readily available leave themselves vulnerable to availability
bias. They overweight information that is readily available and intuitive relative to
information that is less salient and more abstract. People sometimes use heuristics that
feature anchoring and adjustment. In this case they form an estimate by beginning with
an initial number and adjusting to reflect new information or circumstances. However,
they tend to make insufficient adjustments relative to that number, thereby leading to
anchoring bias. People who rely on the affect heuristic base their decisions primarily on
intuition, instinct, and gut feeling.

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Framing Effects
A persons decisions are influenced by the manner in which the setting for the
decision is described. These situations are known as framing effects. Framing is a critical
aspect of prospect theory, the approach that psychologists Kaheman and Tversky
developed to describe how people make decisions involving risk and uncertainty.
Framing effects feature two key behavioral concepts, loss aversion and aversion to a sure
loss. Loss aversion means that psychologically, people experience a loss more acutely
than a gain of the same magnitude. Aversion to a sure loss means that people choose to
accept an actuarially unfair risk in an attempt to avoid a sure loss. Illustrations of both
framing effects are provided using behavior at the firm Merck & Co.

Debiasing
Debiasing is the process of reducing susceptibility to biases and framing effects.
Debiasing turns out to be an enormous challenge. Psychologists have repeatedly
demonstrated that recognizing our errors and biases does not lead us to change our
behavior automatically. Tips for debiasing are offered throughout the book in thematic
boxes entitled Debiasing for Better Decisions. The first example pertains to debiasing
in respect to aversion to a sure loss.

TEACHING TIPS FOR POWERPOINT SLIDES

Before showing the first PowerPoint slide, instructors might begin by
emphasizing to students that this book is a complement to their traditional corporate

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finance text, not a substitute. By using this book as part of their course in corporate
finance, students will learn how to put the traditional tools of corporate finance to their
best use, and mitigate the effects of psychological obstacles that reduce value.
The preceding general point comprises two parts. The first part involves the
nature of the corporate financial decisions that managers make, this being the focus of the
traditional approach to corporate finance. Instructors might remind students briefly what
these decisions entail.
The second part involves psychological phenomena. In making the general point
that specific psychological phenomena are obstacles along the way to value
maximization, instructors might draw students attention to exhibit 1.1, a table that
provides an overview of the main points in the chapter. This table is structured to enable
instructors to highlight a series of concepts.
The most important column in exhibit 1.1 is the left-most column. Instructors can
point to the three categories, namely biases, heuristics, and framing effects, noting that
these categories are the backbone concepts involved in the behavioral approach.
Instructors can then indicate that the 4 biases, 4 heuristics, and 2 framing effects
described in the left-most column constitute the 10 key psychological concepts in the
chapter.
Because exhibit 1.1 is a summary table, at this point there is no need to go into
detail about all entries. Instructors might find it useful to give one example from the
table, such as the line pertaining to excessive optimism. In this regard, instructors can
indicate that the first bias discussed in the course is known as excessive optimism, and
note that excessive optimism can lead managers to make faulty financial decisions, such

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as delayed cost cutting during a recession, that result in the profits of their firms being
lower than necessary.

Slide 1
Slide 1 describes the main points in the Behavioral Pitfalls box about Sun CEO
Scott McNealy. This box provides the backdrop for the discussion about biases and
heuristics. Instructors can indicate the behavioral traits attributed to McNealy in the
BusinessWeek article, and then point to the behaviors mentioned in the article about
McNealys history of taking risks, his resistance to cost cutting during the recession of
2001, his decision for Sun to acquire Cobalt, and resulting decline in Suns sales and
stock price between 2000 and 2004.

Slide 2
Instructors can draw attention to the first behavioral bias, excessive optimism, a
concept illustrated in slide 2. In this illustration, Scott McNealy was excessively
optimistic about the 2001 recession being short, and delayed cost cutting at Sun as a
result.

Slide 3
Slide 3 illustrates what appears to have been excessive optimism by investors
about the value of Sun stock from late 1998 through the second half of 2000.

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Slide 4
Managers can be overconfident about both their own abilities and their
knowledge. Instructors might ask students to volunteer which adjective mentioned in the
BusinessWeek article might be symptoms of overconfidence? Slide 4 suggests that the
answer is cockiness, and illustrates the point using Suns acquisition of Cobalt, which
McNealy admitted was a mistake.

Slide 5
Slide 5 illustrates overconfidence about knowledge, using as an example
McNealys strongly held view that the 2001 recession would be much shorter and sharper
than past recessions. Instructors might ask students for their opinions about how typical
the recession of 2001 was, based on what they see portrayed in exhibit 1.3 displayed in
slide 5. Exhibit 1.3, illustrated in slide 5, suggests that it was not. At this point, it is
important that instructors help students distinguish between excessive optimism and
overconfidence. Exhibit 1.3 suggests that Scott McNealy was indeed excessively
optimistic during the recession of 2001. However, the main point of the slide was that he
was overconfident about his knowledge of recessions, meaning he knew less than he
thought he knew. Overconfident people come to be surprised more frequently than they
anticipated.

Slide 6
Slide 6 illustrates confirmation bias, the tendency to overweight evidence that
confirms our views relative to information that disconfirms our views. The slide makes

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the point that Scott McNealy underweighted information pertaining to Cisco Systems
revenues and to its layoff announcement because that information was at odds with his
view.

Slide 7
Instructors might wish to ask students what the concept illusion of control means
to them. Such a question typically produces a response about people having less control
than they believe they have. Instructors might then amplify the statement to point out that
the outcome emanating from a given decision reflects luck as well as skill. The more
control a manager possesses, the greater the role skill plays relative to luck. Hence,
illusion of control is a phenomenon whereby managers believe themselves to exert more
control than they actually do, thereby underestimating the role of luck (or risk).
Slide 7 illustrates illusion of control using as an example, McNealys decision to
use Suns own chips rather than those produced by industry leader Intel. In retrospect,
McNealy described his great regret over having made that decision.

Slide 8
Slide 8 introduces the first heuristic, representativeness, the overreliance on
stereotypes. Instructors might wish to ask students to imagine how representativeness
might affect the thinking of someone like Scott McNealy, who thinks that the Internet is
becoming increasingly important to the overall economy. Instructors might ask students
to ponder whether representativeness might incline someone like Scott McNealy to view

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technology firms who make products that run the Internet as being representative of the
overall economy?

Slide 9
Slide 9 illustrates the concept of availability, the tendency to rely on information
that is easily available. Instructors can ask students whether Scott McNealys being
distracted by the Microsoft suit might make it difficult for him to give appropriate weight
to customers needs, in this case for low-end servers. Some students might ask how the
concept of availability relates to heuristics. The answer to this question is discussed in the
Additional Resources to Chapter 1 that is available on the text website. A short answer is
that when people over-rely on information that is readily available relative to information
that is less salient, they are said to use the availability heuristic.

Slide 10
Slide 10 illustrates the concept anchoring and adjustment, and should be selfexplanatory.

Slide 11
Slide 11 provides an example of the affect heuristic, the tendency to make
decisions by relying on intuition and gut instinct. Instructors might ask students what they
make of Sun CFO Michael Lehmans remark about behaving differently than corporate
finance textbooks suggest. Instructors can then emphasize that behavioral corporate

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finance is especially relevant if many financial managers do in fact behave differently

than corporate finance textbooks suggest, despite having learned from such textbooks.

Slide 12
Slide 12 introduces the second Behavioral Pitfall box, this time in connection with
the pharmaceutical firm Merck, its CFO Judy Lewent, and its drug Vioxx. Instructors can
ask students if they remember Merck choosing to withdraw Vioxx from the market after
it was found to cause heart attacks and strokes in some patients.

Slide 13
Slide 13 introduces the first of two framing effects, loss aversion. Loss aversion
involves being unduly sensitive to the possibility of loss, thereby overweighting potential
losses relative to potential gains. The example provided in slide 13 involves taking on too
much debt by overweighting the losses associated with defaulting on loans relative to the
tax shield gains associated with taking on additional debt.

Slide 14
Slide 14 introduces the concept aversion to a sure loss. Instructors can emphasize
to students that aversion to a sure loss might sound like loss aversion, but is very
different. Aversion to a sure loss is the tendency to try and beat the odds in order to avoid
having to accept a sure loss. In the example, Mercks managers had information early on
that suggested that Vioxx caused heart attacks and strokes. However, because several of
their blockbuster drugs were going off patent, they framed lower revenues as constituting

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a sure psychological loss. Their decision to try and maximize Vioxxs sales revenues, in
the face of information already at their disposal, suggests that they could not accept a sure
loss, and instead attempted to beat the odds and turn Vioxx into a blockbuster. Had they
accepted a sure loss they would have only targeted people who needed pain relief, did not
appear vulnerable to heart attacks or strokes, and had sensitive stomachs. Doing so would
have resulted in much lower revenues than targeting anyone in need of pain relief.
However, targeting everyone meant that they took the risk that the negative indications
that occurred in small scale trials would not occur in the much larger general population.
Instructors might ask students for their opinions about the role of behavioral
phenomena in the outcome of the first Vioxx trial involving the death of Robert Ernst.
During the trial, Mercks attorneys presented scientific evidence that indicated that the
likelihood of Vioxx having been responsible for Mr. Ernsts death was low. However, the
jury members indicated that they did not understand the scientific arguments presented by
Merck, and were upset at Merck for having concealed information about the connection
between Vioxx and heart attacks. This suggests that the jurys verdict was strongly
influenced by the negative affect that they associated to Merck, and that the affect
heuristic played a role in their decision.

Slide 15
Slide 15 introduces the concept of debiasing, the process of mitigating
susceptibility to psychological phenomena that tend to reduce value. The example of
debiasing in the slide pertains to aversion to a sure loss. Instructors can ask students if

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they perceive themselves to be vulnerable to aversion to a sure loss, and would find the
advice for debiasing helpful.

Additional Resources for Chapter 1 Available on the Web

On the web at www.mhhe.com/shefrin, instructors will find additional resources
that relate to chapter 1. This material is intended for instructors who wish to delve into
the main concepts in greater depth than the level provided in chapter 1 itself. The material
in the additional resources is organized around questions that psychologists have used to
identify the extent to which people are vulnerable to the effects associated with heuristics,
biases, and framing. Instructors who wish to use this material should be aware that the
examples are more generic than those used in chapter 1 proper, in that they are not
explicitly financial in nature.
The first psychological phenomenon presented in chapter 1 is excessive optimism,
and it was illustrated with an example involving Scott McNealy, CEO of Sun
Microsystems. However, the most notable study of excessive optimism in the psychology
literature involved undergraduate students who assessed the relative likelihood of
experiencing a series of life events described on page A1-1. The psychologist who first
conducted the study was Neil Weinstein.
Some instructors might ask their students to answer the diagnostic question on
page A1-1. After having done so, students can separately compute their own individual
average scores for the unfavorable events and favorable events, as described on pages
A1-2 and A1-3. Instructors might ask their students to indicate how many assigned a

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number above 7 to the favorable events and a number less than 7 to the unfavorable
outcomes.
Usually some students will already have read through the material. When this
happens, instructors can ask students to identify whether they have read the discussion of
the life events question in advance, and then compare their responses to the responses of
students who have not read the discussion of life events question in advance. Instructors
can then ask students if they think that being aware of the tendency to be excessively
optimistic will lead them to modify their responses.
Instructors might also seek to identify the magnitude of the general bias. Biases of
10% are common, corresponding to 8 for favorable events and to 6 for unfavorable
events.
A similar approach can be followed with the other questions. For example, in
answering the 10 general knowledge diagnostic questions on page A1-4, students should
be asked to choose low and high guesses that reflect their familiarity with the material
under discussion.
The right answer associated with diagnostic question for confirmation bias
typically elicits complaints from some students about the hypothesis being tested. Some
students misunderstand the hypothesis by interpreting the phrase one side of the card to
mean the side of the card that is facing up. Should students raise the issue, instructors
might wish to ask other members of the class for their opinions about how to interpret the
hypothesis being tested. Typically, even after discussion, some students remain confused
by the distinction.

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Instructors might run a version of the card pool game in their own classes by
using two decks of ordinary playing cards. In the classroom version, students hold cards
they have selected from the first deck, and the instructor picks the winner by choosing a
card at random from the second deck. The winning student holds the twin of the card
selected by the instructor. For example, if the instructor draws the 4 of hearts from the
second deck, then a student who holds the 4 of hearts from the first deck wins the prize.
Notably, there is considerable variability in the way students respond to this diagnostic
question, so there might need to be a large class in order for the main finding to emerge.
The diagnostic question about Linda on page A1-8 typically evokes student
comments about representativeness being sensible, particularly those who succumbed to
the conjunction fallacy. These students might be convinced that Linda is more likely to be
involved in the womens movement than to be a bank teller, and might indicate that they
fail to see why this is an error. Instructors who encounter this reaction can respond by
pointing out that heuristics sometimes give rise to reasonable judgments, but not always.
It might be reasonable to conclude that Linda is more likely to be involved in the
womens movement than to be a bank teller, but is definitely fallacious to form the
judgment that Linda is more likely to be a bank teller who is active in the womens
movement than a bank teller.
Instructors who wish to amplify the discussion about representativeness can pose
the following question.
Suppose that you hear about a graduate student, Tom, from people who know him
well. They tell you that he is intelligent, but is introverted and does not really
enjoy interacting with other people. He has a strong need for order, and likes neat,

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tidy systems. His writing style is somewhat dull, although occasionally quirky.
Although he lacks true creativity, he has a vivid imagination, and appreciates
science fiction.

What Toms friends neglect to tell you is the field in which Tom is a graduate
student. Consider the following list of nine possibilities:
1. Business Administration
2. Computer Science
3. Engineering
4. Humanities and Education
5. Law
6. Library Science
7. Medicine
8. Physical and Life Sciences
9. Social Science and Social Work

Consider two rankings from 1 through 9. The first ranking concerns Toms field of
study. Assign 1 to what you regard as the most likely possibility, and 9 to what
you regard as the least likely possibility. Do this ranking now before moving on to
the second ranking. Remember: 1 means most likely. In the second ranking,
assign a 1 to the field of study you regard as having the most graduate students,
and a 9 to the field of study that you regard as having the least number of graduate
students.

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Instructors can point out that most people attach a high rank to Tom being a
student of engineering or computer science. They attach a lower rank to engineering and
computer science in terms of number of graduate students. The psychological issue
involved in this question pertains to representativeness, and is similar to the example
involving Linda in the chapter text. The key issue is that if there are many more graduate
students in other fields than engineering and computer science, then there may well be
many students in those fields who share Toms traits, even though Tom is not
representative of those fields. Therefore, the size of the field is important to consider
when doing such rankings, not just the degree to which Tom fits the stereotype of an
engineer or computer science student.
When discussing availability bias, instructors might ask students, by show of
hands, for how many the events associated with Hurricane Katrina and New Orleans
came first to mind when reading the diagnostic question? Instructors might then ask
students how many incidents of shark attacks come to mind, noting some particular
identifying detail such as location, approximate date, etc. Instructors might also ask the
same question for injuries stemming from riptides. Students responses to these questions
changed after Hurricane Katrina devastated New Orleans, an event that quickly comes to
mind. Typically, people are able to recall many more deadly incidents involving shark
attacks than from riptides. If there is one riptide incident that is likely to be recalled
easily, it is the death of two people who attempted to save the life of a 10-year old boy at
a Hampton, New Hampshire beach during the July 4 weekend in 2005, when the boy was
pulled out to sea by a riptide.

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Instructors can amplify the discussion about availability by posing the

following question to students.
Both shark attacks and lightning kill Americans every year.
a. On the basis of your recollections, which do you believe to be the more
frequent cause of death in the United States, shark attacks or lightning?
b. Do you believe that the more frequent cause produces more than ten times
as many deaths per year as the less frequent cause? Yes or no?
c. For every death caused by the less frequent cause, how many deaths do
you believe are caused by the more frequent cause?
d. Are there any psychological phenomena to be aware of when answering
the above questions? If so, how should you take these phenomena into
account when answering?

In discussing these questions, instructors can point out that 70 percent of the
1,010 Americans surveyed recently by the National Aquarium in Baltimore, Maryland,
believe that sharks are dangerous. And 72 percent believe that shark populations are just
right or too high.
After a shark attack has occurred and been reported in the media, shark bites and
sightings became major international news. For example, in July 2001, a shark severed
the arm of an eight-year old boy, Jessie Arbogast. The boy was rescued by his uncle, who
wrestled the shark to shore and retrieved the boys arm. This story triggered countless TV
news reports and front-page stories. The Weekly World News tabloid declared: Castro
trained killer sharks to attack U.S.

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There are two psychological phenomena involved in this question. The primary
phenomenon is availability. Shark attacks are more salient in the media than are deaths
from lightning. The second phenomenon is anchoring and adjustment. In the U.S., there
are 250 times as many deaths per year from lightning than from shark attacks.
Availability also features prominently in the minicase about hurricanes.
Instructors can augment the minicase by adding the following anecdote. In August 2004
hurricane Charley passed through Florida causing twenty-five deaths. The community of
Punta Gorda was one of the worst affected. The National Hurricane Center had warned
that Charley would strike a large swath along the west coast of Florida, including Punta
Gorda. Using satellite and radar technology, the Center indicated that the storms bullseye would actually be the city of Tampa. In response, the media focused its attention on
Tampa, and many people were evacuated from the city. However, Charley changed
direction and its bulls-eye lay seventy miles south of Tampa, catching the residents of
Punta Gorda by surprise. The National Hurricane Center was surprised by the Charleys
change in direction, and surprised that the residents of Punta Gorda had not chosen to
evacuate, with the result being more deaths than necessary.
Instructors might ask students what behavioral phenomena they recognize in the
above anecdote. Availability is paramount, in that the media focused attention on Tampa,
so that Tampa became salient, not Punta Gorda. The National Hurricane Center warned
that Punta Gorda was part of the area vulnerable to being struck by Charley. However,
this information was not salient. Another psychological phenomenon at work in the
anecdote is overconfidence. Surprise is the signature of overconfidence. Both the

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residents of Punta Gorda and the National Hurricane Center found themselves surprised
by events.
When discussing anchoring, instructors might augment the example involving
Attila the Hun by giving half the class 5 seconds to estimate the value of the product
1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 x 9 x 10
and the other half of the class 5 seconds to estimate the value of the product
10 x 9 x 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1
Of course both products should be the same, since the only difference is the order of
terms. Yet, students typically multiply the first few terms and extrapolate. Therefore, to
the extent that people are susceptible to anchoring, the students who begin by multiplying
1 x 2 x 3 can be expected to make lower guesses than the students who begin by
multiplying 10 x 9 x 8. However, anchoring and adjustment would induce both groups to
underestimate the value of the product, which is 3,628,800.
The discussion of interacting biases on page A1-11 can serve an integrating
function as well as make a point. The diagnostic question is taken from Weinsteins study
of optimism. Instructors might wish to point out that the general relationship between
optimism and the other behavioral phenomena described on page A1-12 vary across life
events, especially whether the events are favorable or unfavorable.
The backdrop for the discussion of framing effects is the section entitled
Attitudes toward Risk and Loss. This section describes attitude toward risk in terms of
the law of averages.
Instructors might wish to ask students how they would behave when faced with
the decision described in the diagnostic question on page A1-12. After students have

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made their choices, instructors might take an informal poll, writing down the number of
people who chose each of the 4 possible combinations, A and C, A and D, B and C, B and
D.
Instructors might then emphasize the point that people are inclined to be risk
averse when facing choices that only involve the possibility of gains, and risk seeking
when facing choices that only involve the possibility of loss. In discussing this material,
instructors might wish to alert students that the general behavior patterns are complex and
that these issues will be revisited later, notably in respect to chapter 8.
The last behavioral phenomenon discussed in the additional resources pertains to
narrow framing bias. Instructors who took an informal poll of students choice patterns
might compare the number of those choosing A and D with the number choosing B and
C. Thereafter, instructors can take their students through the discussion around exhibit
A1.2, which shows why combination B and C offers $100 more than combination A and
D, no matter whether the outcomes being compared are favorable or unfavorable.

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