In this lesson, you’re expected to learn about:
– identifying irrational behavior in corporate finance
– realizing that emotions and personal judgments play a role in financial decisions
– how to measure irrational behavior
The practice of behavioral finance developed from the need to explain how companies and the people within them behave, steering a course between the fields of finance and psychology. Broadly speaking, behavioral finance looks at people’s actions and reactions, in order to determine how to better understand them and so make better decisions.
In this lesson, we’ll look at some of the irrational and emotional decision-making to watch out for.
Anomalies in behavior develop for good reasons, but frequently they put people in a position of lower efficiency, weaker returns or higher risk.
So you need to go out of your way to study what these behaviors are and what causes them, measure their impact on financial performance and seek to use these behaviors more effectively (or at least minimize them as much as possible).
In your pursuit to be rational in your financial decisions, whether personal or corporate, don’t get too concerned with analysis and preplanning that you become unable to make decisions.
In many situations, you can end up costing a company (or yourself) more money by waiting far too long to make decisions. In such cases, the level of detail and rationality used in your analysis becomes counter-productive.
For example, to be a successful manager of finance, you have to be able to make decisions based on partial information to meet time constraints. In other words, you have to maintain a balance between being as accurate as possible and taking a long time to make a decision.
Making Financial Decisions is Rarely Entirely Rational
Studies in corporate finance make the assumption that people are rational decision-makers. In fact, most economic models, financial and otherwise, assume that people act unemotionally and with a certain degree of competence.
Here’s the reality, though: people are emotional, illogical, impulsive and ignorant.
That’s where behavioral finance comes into play. It defines what’s rational, identifies the causes of irrational financial behavior and measures the financial impact of that behavior.
People rarely make any decisions, much less financial ones, entirely rationally.
Four primary factors (other than corruption) lead people to forgo rationality in favor of some other reasoning technique:
1) Lack of information
2) Lack of time to collect or process the information
3) Lack of ability to understand the information
4) Emotional impulse
When people have a limited ability to take stock of a situation, they often use reasoning methods that rely on experience-based judgments (known as heuristic methods), because people generally trust experience.
Maybe they rely on their ‘gut instinct’, an emotional response with no precisely identifiable cause, or perhaps they choose to employ some loosely applicable general ‘rule’.
Whatever alternative method they use, each one is subjective and, therefore, highly subject to irrationality.
Identifying Logical Fallacies
Logic can be quite complicated. Common sense may get you through the day unscathed, but when you’re dealing with finances, what you really want is good sense. The problem is that human brains have a tendency to try and find patterns in the world around them.
Although this pattern-seeking behavior is necessary for people to function, sometimes it can lead to making incorrect conclusions. When you rely on faulty logic, you’re relying on a fallacy.
Logical fallacies can be based on flawed logic structure, distractions, emotional responses or any number of other factors that use information that isn’t related to the decision at hand.
In finance, a fallacy can lead to a massive mistake resulting from improper judgment.
For example, you may think that a company is a bad investment because the owner is a 20-year-old college dropout, but if every investor had given in to that fallacy, no one would’ve invested in a new company called Microsoft. Fortunately for Microsoft, its investors relied on logical decisions in which they used data in a proper manner, without letting outside sources and unrelated information interfere.
Here are two common fallacies that you may come across in corporate finance:
1) Gambler’s Fallacy
Involves irrationally measuring the probability of an outcome. Imagine that you bought some shares in a company and the share price is spiraling downwards. Instead of selling those shares and investing in something else, you hold onto them because you keep thinking that the share price has to go up eventually, that statistically it can’t go down every single day. That’s naive thinking.
Even assuming an equal probability of increase or decrease in value — that each new day brings a 50% chance that the company’s share price will increase — isn’t accurate, because a poorly performing company has a greater probability of decreasing in value.
This fallacy refers to the idea that a company (or individual) has already put so much money or effort into a project that it has to continue to pursue it at any additional cost. The fallacy is in value assessment and tends to be highly emotionally charged.
In investing, it’s called the disposition effect, which is when investors are more willing to accept gains than losses and end up owning poorly performing shares in a company because they think that the share price is going to go back up eventually.
Needless to say, the company does terribly, and so you continue to pump money into advertising to try to get sales up. You’ve put so much money into the start-up costs (now considered sunk costs because you can’t recover them), and you refuse to accept that investing in this company was a bad idea. Even though the original costs may be sunk already, continuing to put money into the poorly performing company is just making things worse for you.
The world of corporate finance is similar in that people are typically dealing with someone else’s (the company’s) money, and so you may think that emotions run low in corporate finance. But that’s not always the case. Even though they don’t realize it, people working in corporate finance sometimes let their emotions influence their decisions, at least to some extent.
When England won the FIFA World Cup in 1966, UK share prices jumped significantly. Winning the world cup had absolutely nothing to do with the value of these companies, and yet the value of their shares jumped.
Why? Because the mood people are in when making financial decisions influences the decisions they make. When people hear good news, they’re prone to accepting additional risk in their investments. When people receive bad news, they tend to be more wary and avoid risk as much as possible (assuming that they’re not prone to extreme acts of self-destructive behavior that would lead them to do something crazy).
Although this doesn’t change your entire financial strategy (only those with extreme emotional volatility allow an emotional state to dictate their major decisions), when your mood influences your willingness to deviate from rationality, financial inefficiencies do occur, resulting in increased costs or decreased income.
In a single incident, this deviation from rationality may not be entirely damaging, but as more and more people in a company are influenced in this way or a single person is continuously influenced, over time the company can face significant decreases in total financial effectiveness.
Investors have a tendency to get caught up in a stampede of other investors. As soon as some trend starts to occur, investors follow it as quickly as possible, often without even fully understanding why. All they know is that they don’t want to miss out on something big.
Like other forms of behavioral anomaly, this stampeding scenario is influenced by the imperfect distribution of information.
The person may even know that an investment isn’t worth what people are paying for it, and yet he happily pays the same price because the investment has already increased in value so much that he starts to question his original opinion.
– Someone deciding whether the return on a purchase or investment is worth the cost plus risk.
– At least one other person who decides that the return is worth the risk (leading the first person to question the second person’s judgment).
When these two things are in place, you have a behavioral time-bomb of poor financial judgment. This sort of situation is what often leads to bank insolvency, where customers withdraw all their money after losing confidence in the banks (such as what happened in Cyprus).
This situation occurred extremely frequently during the dot com bubble in the 1990s, where many investors lost lots of money when internet companies crashed.