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What Lies Behind Those “Rational” Decisions?

A pioneering book applies behavioral finance to the CFO's world.

Once a fringe subject, behavioral finance is now taught in business schools across the land. The notion that psychological factors can distort financial decision-making is widely accepted, although the effects of such distortions on markets continue to be debated. Most research in the field has focused on investor behavior and asset pricing.

Increasingly, experts are applying behavioral principles to the realm of corporate finance. CFOs are susceptible to psychological biases too, and as a result their judgments and decisions can be less than optimal. Finance executives commonly miss opportunities to maximize value by stumbling into “behavioral traps,” says Hersh Shefrin, the Mario L. Belotti Professor of Finance at Santa Clara University’s Leavey School of Business.

Shefrin, a pioneer in the field, has written a new textbook that suggests how to avoid such traps. The first of its kind, Behavioral Corporate Finance: Decisions That Create Value (McGraw-Hill Irwin, $65) is intended for business-school use, replete with chapter summaries and questions for study. But CFOs who don’t remember the last time they sat in a classroom may also find this slim (200 pages), softcover volume rewarding — particularly if it helps correct expensive habits of thought. (Disclosure: the reporter, who has interviewed Shefrin before, is one of many people named in the acknowledgments.)

The book aims to supplement, not replace, standard texts on corporate finance, says Shefrin. Once students have learned traditional techniques, they can read about the well-established psychological phenomena that can skew the implementation of those techniques. All major areas of corporate finance are covered: capital budgeting, capital structure, valuation, corporate governance, mergers and acquisitions, and more.

Mental Shortcuts

The psychological phenomena, expounded in the opening chapter, come in three kinds: biases, heuristics, and framing effects. Biases, defined as predispositions toward error, are legion; four that commonly mislead managers are excessive optimism, overconfidence, confirmation bias (screening out data that doesn’t support a business case), and the illusion of control.

Heuristics are rules of thumb, or mental shortcuts, used to make decisions. They predispose users to bias. Among those discussed in the book are representativeness, or stereotypic thinking; availability, or relying overmuch on readily available information; and anchoring and adjustment, or becoming fixated on particular numbers, or “anchors.” There are valuation heuristics, too: the P/E, PEG, and price-to-sales heuristics rely on common financial ratios to provide cruder alternatives to the more rigorous discounted-cash-flow approach. And when managers make decisions based on instinct or intuition, they’re simply using another shortcut, the “affect heuristic.”

Finally, framing effects refer to how the settings for decision making are described: the manner of the description can influence the decision. All of these phenomena can and do combine to produce bad financial decisions, says Shefrin. His book provides numerous examples, such as:

• Why did Sony managers wait so long to pull the plug on a disastrous color-television venture in the 1960s? Shefrin thinks they fell prey to a bias called aversion to a sure loss, which, when combined with framing, leads to the “sunk cost fallacy.” The managers’ fear of failure led them to throw good money after bad.

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