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A Behavioral Theory of Corporate Finance

A new academic discipline called behavioral corporate finance challenges conventional ideas about corporate finance and compensation strategies.

(originally published by Booz & Company)

When thinking about a firm’s financing and investment decisions, rational executives are guided by a belief in the efficiency of markets. But what if markets aren’t always as efficient as we believe they are? And what if executives themselves are not rational, and their decisions are biased in some predictable way? This second question, central to research in a new academic discipline called behavioral corporate finance, forces us to reexamine conventional ideas about corporate finance and compensation strategies.

Behavioral finance (of which behavioral corporate finance is a subdiscipline) integrates psychology and economics into the study of human judgment and biases in decision making under conditions of uncertainty. Because of this work, based largely on the pioneering ideas of psychologists Daniel Kahneman and the late Amos Tversky, we no longer automatically assume that markets are efficient or investors rational. In 2002, Professor Kahneman was awarded the Nobel Memorial Prize in economics. (See “Daniel Kahneman: The Thought Leader Interview,” by Michael Schrage, s+b, Winter 2003.)

The application of behavioral finance theory to corporate finance is now attracting the attention of a group of academics, many associated with Jeremy Stein, a professor of economics at Harvard University. Behavioral corporate finance argues that in many senses, corporations are natural arbitrageurs. Research by Malcolm Baker of the Harvard Business School and Jeff Wurgler of New York University suggests it is much easier for a chief financial officer to issue more shares when a company is overvalued than it is for a hedge fund to short overvalued shares; if the shares are not truly overvalued, the consequences to the CFO’s own job are relatively modest compared to those for the hedge fund manager. Indeed, Professor Baker and Professor Wurgler have found evidence that the issuing of equity does coincide with high market valuation. This is not to say CFOs should become market timers and risk developing an inappropriate capital structure for their companies. But the “job security” advantages they have over fund managers imply they should have discretion when faced with irrational market “exuberance” or pessimism.

In this and other ways, behavioral corporate finance has begun to look at the investing and financing decisions of executives within firms. If executives are overconfident or overoptimistic, how are their decisions about capital structure affected? Are there ways to push them toward optimal behavior?

In a bravura piece of empirical research titled “Managing with Style: The Effect of Managers on Firm Policies,” Antoinette Schoar, an assistant professor of finance at MIT’s Sloan School of Management, and Marianne Bertrand, a professor of economics at the University of Chicago Graduate School of Business, demonstrate that there is a pronounced “CEO effect” on decisions regarding capital structure. CEO decisions, they found, reflect a chief executive’s personal style rather than a set of criteria determined by the firm. Financially aggressive CEOs use more leverage and hold less cash on the balance sheet, and many tend to grow their firms through acquisitions. More conservative leaders have more cash on the balance sheet and grow more through internal investments.

These different styles of capital management have real effects on corporate performance. Indeed, the Schoar–Bertrand study showed that conservative CEOs produced a lower rate of return on assets. Aggressive CEOs had higher returns, with the notable exception of those CEOs who made a lot of acquisitions; though considered aggressive, this group had lower returns on assets. The research also found that CEO styles are generational: Older CEOs tend to be more conservative, holding less debt and more cash on their balance sheets.

The real-world implications of this type of research go against much of the prevailing wisdom regarding corporate governance and CEO compensation. At least until the recent spate of corporate scandals, conventional wisdom held that a CEO’s interests should be made to match the firm’s and its shareholders’ interests; thus, stock options that encourage the CEO to seek increases in the share price are an appropriate incentive. But if a CEO is operating according to a persistent bias or particular leadership style, this form of incentive compensation no longer aligns his or her interests with the firm’s. A CEO may do what he or she thinks best, but nonetheless make unsound decisions.

Behavioral finance research indicates that traditional ideas of corporate governance may be too simplistic. The board has to look beyond finding the optimal incentive contract and instead find the CEO with the experience, personality, and management style suited to the company’s actual challenges. But this means the board has to know what type of CEO it needs.

Theories from behavioral finance are at the forefront of explaining differences in corporate financial policies and capital structures. Most important, however, behavioral corporate finance has reintroduced humanity — in all its complexity and subtlety — into corporate finance, where indeed it belongs.

Author profiles:

David E. Adler ( is the coeditor, with Michael A. Bernstein, of Understanding American Economic Decline (Cambridge University Press, 1993). He has produced numerous documentaries for the BBC and is producing a forthcoming PBS special on health care and retirement in the U.S.
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