Understanding How Behavior Affects Corporate Finance
Part of the Corporate Finance For Dummies Cheat Sheet
Behavioral finance was developed as the result of the need to explain how corporations and the people within them behave, driving an overlap between the fields of finance and psychology. Very broadly speaking, behavioral finance looks at the actions and reactions made by people in order to determine how to better understand them and make better decisions.
After identifying the role that an individual plays in the financial world and recognizing what behavioral anomalies each individual is subject to, you can make estimates on the cost of behavioral anomalies and take steps to mitigate the risk that such behaviors will occur. Formalizing and quantifying the role of human behavior in causing deviations from rational financial decisions is a relatively new but very important step to not only understanding but also improving upon the current financial infrastructure of organizations.
Here are few behaviors to keep in mind:
Making financial decisions is rarely entirely rational. Most economic models, financial and otherwise, assume that people act unemotionally and with a certain degree of competence, but in reality, people are emotional, illogical, impulsive, and ignorant. Behavioral finance defines what's rational, identifies the causes of irrational financial behavior, and measures the financial impact of irrational behavior.
Making sound financial decisions involves identifying logical fallacies. Logic can be really complicated. When you rely on faulty logic, you're relying on a fallacy. Logical fallacies can be based on flawed logic structure, distractions, emotional response, or any number of other factors that use information not related to the decision at hand.
Getting emotional about financial decisions can leave you crying. In the world of corporate finance, you're typically dealing with someone else's (the company's) money, so you may think emotions run low in corporate finance. But no matter how far removed you are from the person who actually owns the money you're working with, when you're forced to make a decision, your mood and emotions will influence the decision you make to some extent.
Financial stampeding can get you trampled. As soon as some trend begins to occur, financial investors start to follow that trend as quickly as possible, often without even fully knowing why. Like some other forms of behavioral anomalies, this stampeding scenario is influenced by the imperfect distribution of information.
Letting relationships influence finances can be ruinous. Avoid showing favoritism based on personal relationships rather than merit or qualifications. This form of favoritism is called cronyism (or nepotism, when you're dealing with relatives). Preventing cronyism from occurring in a company is relatively simple at all levels of management except the highest. You just have to require individuals to use predetermined evaluation criteria when making important decisions and then hold them accountable for proper recording and analysis using that criteria.
"Satisficing" can optimize your time and energy. People naturally apply a value to their time. This value isn't so much about money as it is about using your limited amount of time doing things you either need to do or would rather be doing. For a simple example, imagine that you're spending your day off playing video games, and you just can't take time away to go cook dinner. So you decide to order a pizza. You could probably make something healthier, cheaper, and more delicious, but you settle for something that's good enough and doesn't require any additional time or effort on your part. In corporate finance, the application and measurement of what's "good enough" is called satisficing.
Satisficing, in a more practical sense, refers more to our inability to know what is truly rational. Satisficing behavior causes people to make less-than-optimal decisions based on the decision that their time was worth more than the potential benefits. As with all financial decisions, satisficing comes with a degree of uncertainty and risk, so the results can be good or bad.
Prospect theory explains life in the improbable. People's financial decisions are influenced by a behavioral fluke described as the prospect theory, which basically says this:
When making financial decisions that aren't certain (meaning that the outcomes aren't certain but the probability of success can be estimated), people look at the potential for gain or loss instead of relying on rational thinking using the probable outcomes.
People focus on that small probability of the worst-case scenario, and then they act on it.
People are subject to behavioral biases. When you're dealing with corporate finance, you rely on the collection and analysis of data to help you answer questions and make decisions. Even though all the data you need to make the best decision may be available, how you actually perceive and use that data can be an erroneous process thanks to statistical bias and cognitive bias. Statistical bias occurs when people collect data from a sample rather than an entire data set and then assume that the data they collected represent the entire data set. Cognitive bias occurs during the processing of information as people choose to use their own personal judgment rather than the data results.
Analyzing and presenting information can be an erroneous process. How a person processes available data is subject to behavioral errors based on the context in which the data are presented. The process of introducing your own interpretation of a subjective measure or event is called framing. These frames will cause you to understand and interpret things in a different manner from the people around you and, as a result, alter how you each respond.
Framing can influence all sorts of financial decisions. You have to be very careful to apply relevant contextual information along with any analysis you give and ensure that the manner in which you present information remains objective, neutral, and free of judgments that contribute to framing.
Measuring irrationality in finance is rational behavioral finance. Understanding how irrational financial behavior works is only half the job. You also have to determine the value of irrationality. That is to say, you must figure out how much your own inherent irrationality costs you (and your company) financially.