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This article reviews the literature in the field of Behavioral Corporate Finance. For reasons of simplicity, we
distinguish between two approaches. The first approach focuses on the analysis of irrational behavior of managers
in the context of efficient financial markets. Many empirical studies discover systematic irrational managerial
behavior. The second approach regards rational manager decisions in the context of inefficient markets. The
analysis focuses on situations where investors are systematically irrational taking rational and well-informed
managers as given. Interestingly, Behavioral Corporate Finance is able to explain many empirical observations
that cannot be explained by traditional Corporate Finance. In reality, both managers and investors act to some
extent irrationally. Therefore, we make recommendations to both groups in order to improve their decision
making. In contrast to other papers, we give specific recommendations for both managers and investors. With the
help of these recommendations, managers and investors are able to improve decision-making to their mutual
Keywords: Behavioral Finance, Corporate Finance, irrationality, decision-making,manager-investor-relationship, psychological biases, inefficient markets
1. Introduction
Corporate Finance describes the interaction between 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. Investors, on
the other hand, could assume that managers acted self-serving. Therefore, investors would have to offer
incentives bringing the interests of managers in line with their own interests. In reality, however, rational
behavior cannot be assumed for either managers or investors. Instead, Behavioral Corporate Finance shows that
several psychological biases influence decision making of both groups. In this paper, we discuss studies in this
academic field. We distinguish between two approaches.
The first approach focuses on the analysis of irrational behavior of managers in the context of efficient financial
markets. Many empirical studies discover irrational managerial behavior that is systematic. For example, it is
shown that managers are overconfident and excessively optimistic (Ben-David, Graham & Harvey, 2010). Other
psychological biases include anchoring, mental accounting and bounded rationality (Baker, Ruback & Wurgler,
2004; Gervais, 2010).
Table 1. Definition of biases (see also Shefrin, 2007)
Overconfidence Individuals believe that they are better than they really are.
Excessive optimism The frequency of favorable outcomes is overestimated.
Anchoring People anchor on an unimportant number and adjust insufficiently.
Mental accounting Deciding based on different mental accounts.
Bounded rationality Decisions are not rational because individuals are limited in their cognitive abilities and have incomplete information.
Table 1 shows the definitions of those biases. An assumption of the irrational manager approach is that managers
are able to decide on their own and are not entirely controlled by Corporate Governance mechanisms. With
regard to corporate practices, this assumption seems obvious. Empirical studies also come to this conclusion:
Kaplan, Klebanov and Sorensen (2012) for example show that specific character traits of managers affect the
financial development of firms. Bertrand and Schoar (2003) find out that investment decisions are influenced by
the previous professional environment of the managers. Therefore, the assumption that managerial experience
and character affect corporate decisions can be regarded as realistic.
The second approach focuses on situations where investors are systematically irrational taking rational and
well-informed managers as given. This approach assumes managers to be able to distinguish between price and
intrinsic value of a stock. Graham (1973) remarks that price is what investors pay, intrinsic value is what they
get. In order for irrational investors to influence prices, biases must be systematic. If, in addition, arbitrage is
limited, differences between price and intrinsic value can persist. The irrational investor approach assumes that
managers possess an informational advantage over investors. This assumption seems to be realistic for different
reasons: For example, managers are able to engage in earnings management and influence investors by means of
investor-relations policy. Seyhun (1992) confirms that managers are well-informed: He shows that they
outperform the market with legal insider trading (Baker & Wurgler, 2012). Muelbroek (1992) studies illegal
insider trading and also finds that managers earn higher returns than the market.

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It must be assumed that in reality, both parties do not decide completely rationally. Thus, elements of both
approaches work together. In contrast to other papers, we give specific recommendations for both managers and
investors. With the help of those recommendations, managers and investors are able to improve decision-making
to their mutual advantage.
2. Irrational Managers and Efficient Markets
Considering managerial decisions to the disadvantage of shareholders, the literature distinguishes between
intentional and unintentional value reducing decisions. This distinction is very important because the two cases
demand different remedies. Intentional value reducing decisions, where managers try to outsmart shareholders,
lead to agency conflicts which can be solved by correcting incentives. Here, interests of managers should be
brought in line with interests of shareholders. Unintentional value reducing decisions are not in the interest of
shareholders either. However, those decisions do not occur because of different interests between shareholders and
managers. They are rather the consequences of managers’ mistakes (Shefrin, 2007). These mistakes occur due to
psychological reasons and should be avoided through the implementation of management training and education
Figure 1. Managers’ biases and agency conflicts
2.1 Financing Decisions
Loughran and Ritter (2002) explain IPO-Underpricing with mental accounting and anchoring. They assume that
managers who issue shares evaluate the success of those newly issued shares according to two criteria. The first
criterion is the gain that results from the difference between the closing price of the first trading day and the
average price of the price range, with the average price of the price range typically acting as anchor. The second
criterion, which is offset against the first, is the actual loss resulting from Underpricing. If the described gain
more than compensates the Underpricing-loss, the manager typically considers the IPO a success. The theory by
Loughran and Ritter (2002) can explain the empirical finding that Underpricing is more pronounced if the
offering price is above the price range. In this case, managers tolerate a larger Underpricing-loss (Baker, Ruback
& Wurgler, 2004).
With the aid of a survey, Ben-David, Graham and Harvey (2010) show that managers are overconfident and
excessively optimistic. Heaton (2002) demonstrates that 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. Graham (1999) also finds with the help of a
questionnaire that the 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. He attributes this finding to
overconfidence. It explains the reluctance to issue new shares and the preference for internal financing. One
consequence is that investments are avoided or financed with debt if operating cash flow is low. If operating cash
flow is high, however, firms finance their investments internally. The reluctance of overconfident CEOs to issue
shares helps understand the empirical evidence that managerial overconfidence leads to higher debt levels
(Fairchild, 2007). However, the relation between overconfidence and firm value is ambiguous because
overconfidence not only leads to a sub-optimal capital structure but also to higher managerial effort (Fairchild,
2.2 Investment Decisions
Roll (1986) finds out that overconfidence leads to fostering takeovers. Malmendier and Tate (2003) confirm this
assumption: Overconfidence, measured by the frequency executives appear in the public, is positively related to
the number of takeovers. Porter and Singh (2010) discover that managers overestimate synergies and
underestimate costs associated with acquisitions. Therefore, buying offers are often too high and takeovers thusly
are value destroying (Jensen & Ruback, 1983). This finding can explain the fact that acquisition announcements
lead to decreasing stock prices initially as well as in the long run (Andrade, Mitchell & Stafford, 2001).
The stock market thusly reacts correctly to a decision that is typically wrong, at least on average. But not only
takeovers are affected by overconfidence. Landier and Thesmar (2009) show in a survey that initially after
founding, managers of young firms often assume that the future development of the firm will be positive. Only 6
percent of the surveyed managers expect difficulties. Three years later, the managers evaluate the situation more
realistically: Now, already 17 percent of survey participants expect future difficulties.
Cost-estimations of large-scale projects show that managers are excessively optimistic. In retrospect costs are
usually higher than initially expected. Revenues, in contrast, are typically lower than originally expected. Both
effects lead to the acceptance of unfavorable projects due to excessive optimism. Statman and Tyebjee (1985)
demonstrate this for the example of armament projects and pharmaceuticals. Motivated by Statman’s and
Tyebjees’ (1985) research, Pruitt and Gitman (1987) survey executives who confirm that forecasts of large
projects have been too optimistic in retrospect. Moreover, they show that capital budgeting is particularly biased
for managers with a long work experience (see also Fairchild, 2007).
Malmendier and Tate (2005) compare the stock market development of firms run by awarded managers with a
control group and discover underperformance. Moreover, they show that those companies’ incomes develop
worse than incomes of control group companies. Malmendier and Tate (2005) reason that 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.
Bounded rationality decision making does not incorporate the entire complexity of the problem (Simon, 1955).
Instead, decisions are made with rules of thumb and therefore are often wrong-headed. Gitman and Forrester
(1977), for example, show in a survey that Internal Rate of Return (IRR) is typically preferred over Net Present
Value (NPV) for evaluating investments, although NPV is more exact. In another survey, Graham and Harvey
(2001) find out that more than half of all managers use a simple amortization method that does not take into
account capital cost and cash that comes in after the amortization period. However, it is argued that the
amortization method is useful for firms that are severely capital constrained (Shefrin, 2007).
Welch (2004) discovers that the capital structure in reality is not adjusted to stock price fluctuations as suggested
by rational models (see also Subrahmanyam, 2007). Graham and Harvey (2001) confirm this finding. They show
with the help of a survey that book values – and not market values – are used for capital structure targets in
reality. This finding is remarkable given the fact that market values can critically deviate from book values,
especially in case of equity capital (see also Baker, Ruback & Wurgler, 2004). A further result of the survey is
that most managers use a single discount rate for all projects within the firm. In theory the discount rate should
change depending on the risk of the prevailing project, but according to the questionnaire fewer than 10 percent
use different discount rates for different projects. Admittedly, however, managers of larger firms are more likely
to employ discount rates that match risk characteristics (see also Shefrin, 2007). A single discount rate for the
whole firm leads to favoring of high-risk projects and discrimination of low-risk projects. Thus, the mentioned
simplification results in suboptimal investment choices.
Prospect theory assumes that individuals are risk averse in the positive and risk seeking in the negative domain.
Faced with a choice between a gamble and a sure loss, individuals tend to opt for the gamble (Kahneman &
Tversky, 1979). Combining mental accounting with prospect theory preferences, managers hold on to less
successful projects even if those projects should be finished under rational criteria (Fairchild, 2007). Hoping to
break even, managers typically throw good money after bad. This phenomenon explains why the stock market
reaction to finishing announcements of loss-making projects is on average positive (Statman & Sepe, 1989;
Baker, Ruback & Wurgler, 2004). In order to give an overview, we summarize the studies about irrational
managerial behavior in appendix A.
3. Irrational Investors and Rational Managers
In the literature, rational managers keep a balance between three goals, namely market timing, catering and
increasing intrinsic value (see Figure 2). Market timing relates to decisions that aim at exploiting temporary
mispricing, for example by issuing overvalued or repurchasing undervalued shares. Catering refers to decisions
that aim at boosting stock prices above the level of intrinsic value. Increasing intrinsic value is self-explanatory.
Rational managers’ objectives in irrational markets Market timing Catering Increasing intrinsic value
Figure 2. Rational managers’ objectives
3.1 Financing Decisions
The fact that new issues underperform in the long run spurs speculations that managers tend to issue stocks,
particularly if they are overvalued. Loughran and Ritter (1997) and Ikenberry, Lakonishok and Vermaelen (2000),
for example, show that 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. It can be assumed that wealth is knowingly
transferred from new to existing shareholders (Baker & Wurgler, 2012). This theory is confirmed by the findings
of Burch, Christie and Nanda (2004). They consider the return difference between stocks issued to existing
investors with subscription rights and stocks issued to new investors for the US-market from 1933 to 1949 and
show that only stocks issued to new investors underperform in comparison to the market.
Another remarkable result is that stocks are issued predominantly when the subsequent performance of the
aggregate market is below-average. Baker and Wurgler (2000), for example, show that the US-market
underperforms compared to the historical performance when the number of new issues is in the top-quarter. The
investment horizon considered by Baker and Wurgler (2000) is one year. Henderson, Jegadeesh and Weissbach
(2006) demonstrate for other countries that firms tend to issue stocks when the development of the aggregate
market is below-average in the subsequent year. Loughran, Ritter and Rydqvist (1994) show that the number of
IPOs is particularly high in times when valuation ratios indicate that the market is overvalued. Pagano, Panetta
and Zingales (1998) find out that firms arrange SEOs when the Price Book Ratio (PB) of their industry is

In addition, Jung, Kim and Stulz (1996) show that firms tend to issue stocks when the firm has a high PB in
comparison to the historical average PB of the firm. These findings indicate that managers possess an
information advantage over investors and issue new stocks if they are overvalued. This reasoning is in line with
Jenter (2005). He shows that shortly before and after SEOs an above average number of managers engage in
insider selling. In the survey of Graham and Harvey (2001), about 66 percent of managers state that
overvaluation is an important or very important criterion for the decision to issue shares (Baker & Wurgler,
2012). Huh and Subrahmanyam (2005) demonstrate for SEOs that mainly private investors buy issued shares.
The authors attribute this finding to the fact that those investors are particularly attracted by the stock increases
that typically happen before the issue. According to the authors, those private investors assume that stock prices
rise further, even after the issue. This assumption, however, turns out to be wrong in most cases (Loughran &
Ritter, 1997).
In summary, investors should be skeptical towards new issues for at least two reasons: First, newly issued shares
underperform compared to the aggregate market. Secondly, newly issued shares are typically issued when the
aggregate market or the industry is at a high or at an interim high. Ikenberry, Lakonishok and Vermaelen (1995)
show that stocks repurchased by firms earn better returns than the market. Just as the underperformance of new
issued stocks can be explained by overvaluation, the outperformance of repurchased stocks can be explained by
undervaluation. Asked by Brav, Graham, Harvey and Michaely (2005), managers say that they consider
undervaluation indeed as an important criterion for repurchases.
Hong, Wang and Yu (2008) find out that firms repurchase their own shares especially after stock market
decreases. Grinstein and Michaely (2005) demonstrate that in comparison to individual investors, institutional
investors seem to appreciate repurchases. This finding may explain that stocks show a positive initial reaction of
3.5 percent after the repurchase announcement (Shefrin, 2007). Dichev (2007) asks how equity capital cost
decrease due to the timing of new issues and buybacks. For 19 different markets, the mean reduction of equity
capital cost is 1.5 percent per year. Thus, if firms did not time their new issues and repurchases they would have
to bear 1.5 percent higher equity capital cost.
Marsh (1982) asks whether firms not only time equity but also debt issues. He shows that the interest rate level
influences the decision whether to issue stocks or bonds. Guedes and Opler (1996) demonstrate that for newly
issued bonds there is a negative correlation between duration and the interest differential between long- and short
term interest rates. These interesting results are in line with the survey of Graham and Harvey (2001) which
shows that the majority of managers consider the interest rate level as the most important criterion whether or
not to issue new bonds (Graham & Harvey, 2001). Moreover, managers declare that the decision whether to
choose long or short-term debt is influenced by the yield curve.
Spiess and Affleck-Graves (1999) study stock performance of firms that have issued bonds or convertible bonds
from 1975 to 1989. Considering an investment horizon of five years, they find that stocks of both groups
underperform in comparison to a control group. In this study the control group was chosen based on size and PB.
Stocks of firms that have issued convertible bonds perform even worse than stocks of firms that have issued
ordinary bonds (Baker & Wurgler, 2012). However, stocks of firms that have issued ordinary bonds underperform as well. An explanation for this finding is that managers pretty up their companies when issuing bonds in order to appear creditworthy. Investors seem to be influenced and buy overvalued stocks that subsequently underperform.
Given that financial decisions of managers depend on market situations, it can be assumed that past valuation
influences the capital structure of a firm. Baker and Wurgler (2002) find that there is a negative relationship
between the average past PB of a firm and the relation between debt and equity (see also Barberis & Thaler,
2003). Baker and Wurgler (2002) explain their result with the fact that financing decisions of firms depend on
under- and overvaluation of stocks. A contrarian opinion comes from Hovakimian (2006). He argues that
average PB explains the relation between debt and equity because PB includes information about growth
prospects of firms. According to Hovakimian (2006), those growth prospects in turn influence the target capital
3.2 Investment Decisions
Shleifer and Vishny (2003) develop a theory for corporate takeovers. They suppose that firms undertake
acquisitions if their own stocks are an attractive currency to finance the purchase (Subrahmanyam, 2007). Shleifer
and Vishny (2003) reason that stock financed takeovers are advantageous for the buyer if stocks of the target firm
are less overvalued than stocks of the buying firm. In this case, shareowners of the buyer benefit because
overvaluation of their shares decreases due to the takeover. According to Shleifer and Vishny (2003),
overvalued firms gain if they pay with own shares. Undervalued firms, in contrast, should prefer to pay in cash.
Therefore, the theory is able to explain the empirical fact that the subsequent stock performance of firms
financing takeovers with stocks is worse than the subsequent stock performance of firms that pay in cash (Rau &
Vermaelen, 1998).
Ang and Cheng (2006) study the correlation between valuation ratios and the number of takeovers. They find a
positive link and in addition demonstrate that according to PB, buying firms are more overvalued than acquired
firms. Baker, Foley and Wurgler (2009) show that cross border takeovers increase when the mean PB in the
home country of buying firms rises. This finding also indicates that firms exploit overvaluation of own shares.
Baker, Coval and Stein (2007) ask why overvalued companies undertake acquisitions and do not issue stocks.
They conclude that the reason may be investor preferences: Investors take the path of least resistance and agree
to takeovers. But those investors would not actively buy new stocks according to Baker, Coval and Stein (2007).
Considering takeovers, the choice between diversification and focus is of special interest. Rational theory cannot
explain why there are periods with remarkably many diversification takeovers from time to time. These periods
are called conglomerate waves (Ravenscraft & Scherer, 1987). One of those conglomerate waves started in the
mid-1960s and culminated in 1968. Ravenscraft and Scherer (1987) focus on that period. They find out that
investors who held conglomerates from 1965 to 1968 earned a return that was more than three times higher than
the return of the aggregate market. But from 1968 to 1970, conglomerates underperformed by a large margin
(Baker & Wurgler, 2012). Moreover, until 1968 stocks reacted initially positive when diversification takeovers
where announced (Matsusaka, 1993). After 1968, however, there was no such positive effect (Morck, Shleifer
and Vishny, 1990).
Accordingly, Klein (2001) shows that conglomerates traded at a premium until 1968 and thereafter at a discount
(Baker & Wurgler, 2012; Klein, 2001). Conglomerate waves can be explained by an irrational investor
preference for diversified firms. According to Baker and Wurgler (2012), managers react opportunistically and
cater to the demands of investors by diversifying, even though they accept the risk of destroying long-term value
by doing so. This reaction is quite rational since it boosts managers’ compensation and often secures their job. If
conglomerates get out of fashion later, opportunistic managers react and divest subsidiaries again.
The question is whether irrational investor behavior affects real investment: As already demonstrated, managers
often time new issues. They offer shares when those are overvalued. In his model, Stein (1996) supposes firms
that are not dependent on equity and managers that increase long-term value. He shows that those managers will
not ultimately invest additional capital that comes from new issues because they know that investor optimism
referring to additional projects is not justified. Therefore, overvaluation should not influence real investment
behavior of firms (Barberis & Thaler, 2003). Equally, an undervaluation that leads to repurchases will not
influence investment behavior if the assumptions of Stein’s (1996) model hold.
One can assume, however, that in reality both model assumptions do not hold without restrictions: First, one has
to assume that many firms, particularly heavily leveraged firms, are in need of equity. Secondly, it is not realistic
to suppose that all managers only want to increase long-term firm value. It is possible, for example, that a real
world manager is opportunistic. Accordingly, he or she will undertake a project liked by investors even if it does
not create long-term value, because otherwise the manager would run the risk of losing his or her job. One
reason is that a hostile takeover becomes more likely to happen if the stock decreases. But of course, the
manager can also be laid off directly if shareholders are not satisfied with his or her performance.
Several studies test whether mispricing of stocks influences real investment behavior. Baker and Wurgler (2002)
measure overvaluation of single stocks with PB: They show that firms with high PBs issue more than the
average number of shares. But usually the funds are not used for additional real investments. Instead, firms boost
cash reserves. Blanchard, Rhee and Summers (1993) study aggregate market mispricing for the US-market.
Using Tobin’s Q, they show that mispricing is only marginally related to real investment for the time span from
1920 to 1990. Gilchrist, Himmelberg and Huberman (2005) study stock market bubbles and come to a different
conclusion than Baker and Wurgler (2002) or Blanchard, Rhee and Summers (1993): They show that mispricing
not only influences finance- but also real investment behavior. Polk and Sapienza (2009) also demonstrate that
real investment is affected. They find that real investment heavily depends on mispricing in particular for firms
with short-term oriented shareholders (Baker & Wurgler, 2012). Polk and Sapienza (2009) measure investment
horizon with the help of the average stock turnover of a company.
judge the equity-dependence by the amount of liquid funds. As supposed, the study shows that particularly for
equity-dependent firms, investment varies with mispricing. For less equity-dependent firms, investment varies
less (Barberis & Thaler, 2003). In summary, we can notice that there are indications that irrational investor
behavior influences corporate investment, at least partly. It cannot be said for sure, however, to which extent,
investments are a rational response to overvaluation, or whether they are irrational in themselves. In order to
answer this question, further research is necessary. Appendix B gives an overview of the studies about irrational
behavior of investors and rational managerial responses.
4. Recommendations for Managers and Investors
The previous parts of this paper show that the assumption of rational behavior is not realistic. Instead, managers
and investors make mistakes. Next to summing up currently predominant research, we give advice for managers
and investors in order for them to foster mutual success. The mistakes mentioned in this paper are systematical.
The question is how to prevent them. Debiasing is difficult because the psychology that forms the basis of those
mistakes is very robust. Of course, individuals are able to learn about biases but learning takes very long.
Therefore, debiasing needs time and effort. Moreover the complexity varies from situation to situation. If feedback
comes in fast and is clear, it is easier to realize mistakes than if feedback comes in slow and is ambiguous. In many
situations of the corporate world, the time span between the decision and the ultimate outcome is very long and it is
difficult to link the outcome to the decision. Therefore, it is complicated enough to realize mistakes. Avoiding
future mistakes is even more complicated. (Shefrin, 2007) Let’s now ask how to improve decision making for both
investors and managers concretely.
Investors can of course influence investment success by making good buying and selling decisions. This is
obvious and a scientifically accepted fact. Beyond that, however, investment success is determined by the
actions of managers. As demonstrated above, managers are able to create value for investors through good
capital allocation- and financing decisions. But it is also crucial that investors are able to appreciate that; only if this is the case they can choose capable managers and provide effective incentives. If effective incentives are
installed, value enhancing decisions are favorable for capable managers, too: A mutually beneficial situation
emerges. In the selection of managers, investors should not only consider managerial actions but also the
motives behind the actions. It may well make sense for long-term oriented investors if managers repurchase
shares because of their undervaluation. But repurchases are also often implemented for wrong, that is not value
oriented, reasons.
Managers frequently repurchase shares in order to increase demand for price stabilization reasons. If that is the
reason, investors should be suspicious. This motive eventually does not tell anything about whether buybacks
create or destroy value. Investors should moreover be skeptical towards management that in the past frequently
engaged in takeovers that proved to be value destroying in retrospect. It is likely that overconfidence leads to
value destroying transactions in the future, too. If capable managers encounter uninformed investors, managers
can try to give investors an understanding of value oriented management. An annual report, for example, does
not only have to be used to report about the last financial year but can also be an instrument to enlighten
investors about good and value increasing business principles. Berkshire Hathaway provides a good example
how loyal investors can learn from management in a relationship that is based on trust and honesty.
shareholders are not considered faceless figures in an ever shifting crowd. Instead they are treated as long-term
partners. In this case, time and effort to familiarize investors with value increasing business principles pay off for the management. Investors learn, become better stewards and are able to better evaluate corporate decisions.
In many firms however, this does not work as well as in the mentioned example. Often, there is a danger that
investors do not know what is in their own best interest. In this case it is possible that investors provide the
wrong incentives for managers and it does not pay off for managers to make decisions that are in the interests of
investors. Then, controlling managers is not beneficial to increasing long-term value. There are many companies,
particularly smaller ones, which shy away from entering the capital market for exactly that reason: They do not
want to make themselves dependent on short-term oriented and irrational investors. The situation is often not
improved by the fact that investors do not control management directly but by means of a board.
Executives should confine themselves to value oriented management. This would render earnings management
and other accounting manipulating actions unnecessary. However, informed investors are needed to provide
incentives that ensure that not earnings manipulation but value increasing actions pay off for managers.
Sometimes it is beneficial if managers are shareholders themselves and are not allowed to sell their shares for a
while – managers would have to eat their own cooking. It is common but not advisable to link payment to the
mere size of a company. Instead, it is better to link payment to per share value.
successful relationship between managers and shareholders. Managers should ensure not to raise expectations
that they cannot fulfill. This is the best way for a mutually beneficial relationship (see Berkshire Hathaway
Annual Reports).
Complicated questions for managers arise in the context of new and parting shareholders: Should managers issue
overvalued shares to new investors in order to create value for existing shareholders? Managers could justify this
step with their obligation towards existing shareholders. At the time of the capital increase, one could argue, they
are not yet obligated towards new shareholders. But it is possible that these new shareholders ask themselves in
retrospect whether they can trust management that has exploited its information advantage and sold them
overvalued shares. In this case the relationship may be adversely affected from the very beginning.
5. Conclusion
Research in the field of Behavioral Corporate Finance shows that managers as well as investors act irrationally –
at least partly. The recommendations in this paper aim at helping both groups to change decisions. The approach
that explains not only investor but also management decisions by psychology is relatively new and accordingly,
irrational managerial behavior has up-to-date not yet been included in behavioral models. A model that considers
not only investor but also managerial choices and interdependencies would be a path-breaking progress
compared to the present one-dimensional behavioral models.
As demonstrated in this paper, much of the past studies have focused on overconfidence, excessive optimism and
bounded rationality. But Statman and Caldway (1987) show for example that executives exhibit many biases
when they decide about corporate investments that are similar to those of investors (see also Fairchild, 2007).
But more concrete results are needed. Therefore, further research is necessary.
Behavioral finance is the examination of the behaviors managers’ exhibit in decision-making situations and how the psychological factors impact the individual and the financial decisions they make on the behalf of their corporation (Ackert & Deaves, 2010). Tristan Nguyen and Alexander Schubler’s article How to Make Better Decisions? Lessons Learned from Behavioral Corporate Financereveals two approaches to analyzing behavioral finance and its impact on corporations (2012). Nguyen and Schubler’s informative analysis of irrational and rational behaviors of corporate managers impact on the financial practices and performances of their businesses.
The presence of multiple biases and the interactions between management and investors all play a major role in determining and sustaining a company’s value. According to Traditional Theory, managers and investors both act rationally when it comes to considering and performing acts that are for the best of the corporation in oppose to acts that are in their best interests (Nguyen & Schubler, 2012). However, as Nguyen and Schubler’s article reveals, at times there is an absence of rational reasoning and irrational behaviors consume the actions of these individuals. According to documented studies, irrational behaviors in managers are systematic and have a lasting effect on the business overall.
Irrational Managers and Efficient Markets
An efficient market is defined as a market in which investors can make decisions to choose between securities that represent a stake in the company or the company’s practices (Ackert & Deaves, 2010). The efficiency relies on whether the price of securities represents all information available about the company. According to Nguyen and Schubler, in analyzing the irrational behaviors of managers, they established there are various biases that are the cause of the conflicts that effect the valuing decisions being made. Biases such as overconfidence, excessive optimism, anchoring, mental accounting and bounded rationality (Shefrin, 2007) are some that can affect the character of a manager. The impact of the effect can alter their behaviors in relation to how they perform in relation to the firm’s financial development (Nguyen & Schubler, 2012). The article considers how these physiological biases are a disadvantage to the financial performance of a corporation.
Nguyen and Schubler recognizes the irrational manager approach as one that is not directly controlled by standard Corporate Governance and acknowledges the presence of other factors related to their performance. These factors, also referred to as biases, are defined within Shefrin’stext (2007) in a manner that relates to corporate management. Of all the biases, overconfidence is characteristic that is present in most irrational and rational managers. When a manager is overconfident, they have a strong belief that they can perform better than they actually can. According to studies (Ben-David, Graham & Harvey, 2001) managers whom are overconfident are also excessively optimistic. The excessive optimism within managers is risky as they tend to believe in favorable outcomes more often than others.
Within efficient markets, where a continuous return is received on the capital invested within the stocks, Nguyen and Schublerreveal mistakes made within these markets are due to managerial errors caused by psychological issues. According to the Irrational Investors and Rational Managers Investment and Financial Decisions
Nguyen and Schubler’s Recommendations .Conclusion
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