Monday, October 18, 2004

More on Behavioral Finance

What a great article! It is a survey article on Behavioral Corporate Finance by Baker, Ruback, adn Wurgler. It is VERY good! Here is their abstract:

Research in behavioral corporate finance takes two distinct approaches. The first emphasizes that investors are less than fully rational. It views managerial financing and investment decisions as rational responses to securities market mispricing.

The second approach emphasizes that managers are less than fully rational. It studies the effect of nonstandard preferences and judgmental biases on managerial decisions. This survey reviews the theory, empirical challenges, and current evidence pertaining to each approach. Overall, the behavioral approaches help to explain a number of important financing and investment patterns. The survey closes with a list of open questions.

Still not convinced that you should read the paper? How about this quote:

"...when the primary source of irrationality is on the investor side, long-term value maximization and economic efficiency requires insulating managers from short-term share price pressures. Managers need to be insulated to achieve the flexibility necessary to make decisions that may be unpopular in the marketplace. This may imply benefits from internal capital markets, barriers to takeovers, and so forth. On the other hand, if the main source of irrationality is on the managerial side, efficiency requires reducing discretion and obligating managers to respond to market price signals.

The stark contrast between the normative implications of these two approaches to behavioral corporate finance is one reason why the area is fascinating, and why more work in the area is needed.

Very interesting! This is going to "appear in the Handbook in Corporate Finance: Empirical Corporate Finance, which is edited by Espen Eckbo."


j david said...


Don't all "non-behavioral" financial models begin with the "behavioral" assumption that all investors have mean-variance preferences? This implies (more correctly it defines) a certain form of utility function.

Doesn't so-called "behavioral" finance simply make this assumption explicit, and allow other assumptions to be tested? As I recall, one can readily identify about a half dozen "forms" (mathematically) of utility/risk preference curves that explain the vast majority of individual decision patterns. It seems that behavioral finance is just a logical extension of the field.

What am I missing?

FinanceProfessor said...

I agree with your comment and think it is important in the bigger picture. When we speak of a market being efficient we should be more careful and specify whether we are speaking of mean-variancce efficiency, or some other definition of efficiency.

This is one of the problems when we try to test what is efficient. What is meant by efficiency? Is it just mean-variance efficient (MVE)? Or is it a bigger picture.

For instance I have mentioned in class that suppose we were to find that land mine or tobacco firms earned "abnormally" high returns on a risk adjusted basis. This could be because investors would rather not hold these shares, but like most things, will do so for the right price or because the market mispriced the assets. The distinction is important and often (almost generally) ignored.