Sunday, July 12, 2009

Behavioral finance and corporate finance

I wrote my first corporate finance book in the 1990s and Corporate Finance remains my favorite subject to teach, since it forces me to think about how businesses should be run and not just about investing in these businesses. It is a constant reminder that it is great business people who create strong economies and not great investors. As a linear thinker who likes my ducks in a row, my vision of corporate finance has always been built around maximizing the value of a business (rather than stock prices) and how investing, financing and dividend policy should be set by a firm (private or public), with this objective in mind.

Over the last two decades, behavioral finance has become the fastest growing area in finance. Much of the early work was directed at how investors behave: studies indicated that investors suffering from over confidence, and with skewed estimates of their own ability and likelihood of success, tend to drive stock prices away from "rational" levels. In the last decade, behavioral finance has started making inroads into corporate finance, looking at how managers in publicly traded firms behave and finding, to no surprise, that they exhibit the same frailties that we see with the investing public. Over confident managers over estimate cash flows on projects, use too much debt and tend to feel that their stocks are under valued (thus explaining the reluctance to use new stock issues).

I must confess that I have been a skeptic about behavioral finance and there is almost no mention of it in any of my corporate finance books. I have tried to at least partially remedy that defect in the third edition of my Applied Corporate Finance book that will get to the book stores later this year. Why this capitulation and why now? Though it is easy to attribute everything to the market crisis of 2008, this has been building up for a longer period and these are some of my reasons:

a. Some of the initial work in behavioral finance was designed more for shock appeal and clearly aimed at shaking up establishment thinking (which needed shaking up). The early papers in the area took great glee in pointing out the failures of traditional finance but offered little in terms of how to do things better. In recent years, there have been two signs that the area is maturing. The first is that disagreements are popping up between behavioral finance researchers on key issues in behavioral finance. The second is that more of the literature in recent years has started looking beyond the descriptive component to prescriptions. In other words, rather than just tell us that managers fail to ignore sunk costs in decision making, we are seeing more discussion of how best to design systems that may minimize the costs from this tendency.

b. Traditional finance, by ignoring management (and human) proclivities, has given both theorists and practitioners an easy pass. It allows academics (who have never had to run a business) to lecture managers about how "irrational" they are in their decision making, and it allows managers to ignore basic principles on investing and financing, by pointing to the ivory towers that academics live in and the unrealistic assumptions they make to get to their conclusions.

As I tried to incorporate what I know about behavioral finance into my corporate finance big picture, I was struck by the tension between describing things as they are and describing things as they should be. It is true that managers often behave in ways that are inconsistent with traditional basic financial principles and it is also true that we can trace the way managers behave to quirks in human behavior. I understand why managers over invest, borrow too much or too little, are reluctant to issue new equity and buy back too much stock. I also believe that I cannot abandon talking about what managers should be doing and why their actions cost stockholders money. I tried my best to walk that fine line in my new edition and I will talk about my conclusions in pieces in the next few posts.


Mahesh Sethuraman said...

What a co-incidence.I just started reading “Nudge” by Richard Thaler and Cass Sunstein. I think its a made a huge leap in the field of behavioral economics moving from one that finds flaws in others' theoritical arguments to one that has solutions on offer though it is in the con text of decision making in every aspect of life and not just about economics or finance.

I remember going thru the website of Mr.Thaler's fund management company in which the strategies mentioned to exploit behavioral anomalies look suspiciously similar to value investing strategies with a more elegant explanation, In the field of finance, I understand that it offers a great insight in judging things retrospectively but can behavioral finance really offer a prospective solution? If that is the case, shouldn't we have seen a huge diversion of funds from conventional fund management companies to Thaler kind of funds already?

Aswath Damodaran said...

I think behavioral finance can do two things well: explain past behavior and explain why prices are different from true value. I don't think it is particularly useful in predicting the future. That is why investment strategies based upon it tend to fail.

Trust - Me said...

It is 'relatively' easy to determine if people are being irrational, but much more difficult in determining how long people can stay irrational. I would argue most times it is not predictable, i.e. mostly random.

Case and point, the hedge funds that may have seen the housing bubble, but were way too early on the call.

Which brings to made the trading motto: "If you're early, you're wrong."

Felipe Bicalho said...

" allows managers to ignore basic principles on investing and financing, by pointing to the ivory towers that academics live in and the unrealistic assumptions they make to get to their conclusions."

I think that every single word that you wrote is true. I'm looking foward for your book.

Any possibility that it may come out in portuguese?

Bhaskar said...

rationality is harder to measure as to describe for any manager. also, baysean updating will not be an easy statistic approach. so, how can we study, say the dynamics of corporate finance decisions based on the behavorial approach ?

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DC said...

Thought you might enjoy this TED video that explores some of the decision making biases common to investing and being in love. Keep producing great content on behavioral finance!

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