Understanding How Behaviour Affects Corporate Finance - dummies

Understanding How Behaviour Affects Corporate Finance

Part of Corporate Finance For Dummies Cheat Sheet (UK Edition)

Behavioural finance was developed as a result of the need to explain how companies and the people within them behave, as an overlap between the fields of finance and psychology. Very broadly speaking, behavioural finance looks at the actions and reactions people make 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 recognising the behavioural anomalies to which each individual is subject, you can make estimates of the cost of behavioural anomalies and take steps to mitigate the risk that such behaviours incur.

Formalising and quantifying the role of human behaviour in causing deviations from rational financial decisions is a relatively new but very important step in understanding and improving upon the current financial infrastructure of organisations.

Here are a few behaviours 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. Behavioural finance defines what’s rational, identifies the causes of irrational behaviour and measures the financial impact of irrational behaviour.

  • Making sound financial decisions involves identifying logical fallacies. 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 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, and so you may think that emotions run low in corporate finance. But no matter how far removed you are from the person who owns the money you’re working with, when you’re forced to make a decision, your mood and emotions influence the decisions you make.

  • Stampeding can get you trampled. As soon as a trend begins to occur, financial investors start to follow that trend as quickly as possible, often without fully knowing why. Like some other forms of behavioural anomaly, this stampeding scenario is influenced by the imperfect distribution of information.

  • Letting relationships influence finances can be dangerous. Avoid showing favouritism based on personal relationships rather than merit or qualifications. Preventing cronyism (or nepotism when you’re dealing with relatives) 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 optimise your time and energy. People naturally apply a value to their time. This value isn’t so much about money as about using your limited amount of time doing things you need to do or would rather be doing. For a simple example, imagine that you’re going out to a restaurant that is only a 20-minute walk away from your house, but you decide that walking is too much trouble, so you call a cab. You’re more than capable of walking to the restaurant but you choose another means of getting there that is 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 people’s inability to know what’s truly rational. Satisficing behaviour causes them 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, and so the results can be good or bad.

  • Explaining life in the improbable. People’s financial decisions are influenced by a behavioural fluke described as the prospect theory, which basically says that:

    When making financial decisions that aren’t certain (meaning 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 act on it.

  • Understanding that people are subject to behavioural 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 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 collect represents the entire data set.

    • Cognitive bias occurs during the processing of information as people choose to use their own personal judgement rather than the results of the data.

  • Analysing and presenting information can be an erroneous process. How a person processes the available data is subject to behavioural errors based on the context in which that data is presented. The process of introducing your own interpretation of a subjective measure or event is called framing. These frames help 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 judgements that contribute to framing.

  • Measuring irrationality in finance is rational behavioural finance. Understanding how irrational finance behaviour works is only half the job. You also have to determine the value of irrationality: that is, you need to work out how much your own inherent irrationality costs you (and the company) financially.