Understanding Behavioral Corporate Finance

Most proponents of behavioural finance argue that psychological forces interfere with all the three traditional components of the corporate finance which consists of efficient market, CAPM and rational behaviour.  Thus it prevents decision makers from acting and making decision in a rational manner.

There are two key behavioural impediments to the process of value maximization, which are from internal and external side of the firm. The first one (from the internal point of view) is considered as behavioural costs, which tend to undermine value creation. The word costs, alternatively means loss in value associated with errors made by managers emotionally or because of cognitive imperfections. While the external factors stems from behavioural errors made by analysts and investors.

Most people particularly practitioners and academics tend to focus on agency cost when discussing about value-based management issues. Agency cost occurs when conflict arises between agents (i.e managers) and principals they have been engaged to serve (i.e stockholders or firm owners). Most value-based management proponents suggest that through properly design incentives, it will encourage managers to maximize the value of the firms for which they work.

However there’s always a limitations to what incentives can achieve if employees have a distorted or mistaken view of what actions they need to take in order to maximize their self-interest. That considered as the ‘costs’ that firm has to pay and could devalue its reputations as well as other shareholders’ interest. Here it does not mean incentives are irrelevant, but since behavioural costs can be quite large, therefore firms cannot depend on incentives alone and it cannot be considered as the solution to purge agency problem.

On the external side, one of the behavioural obstacles argued by most behavioural finance proponents is when the risk is not priced in accordance with the CAPM and that market forces often deviate from fundamental values. This argument can be further proven with evidences which also have been widely documented in many of value-based management literatures.


To understand more about the internal behavioural related obstacle, take the case of Sony Corp as example. Masura Ibuka and Akio Morita founded Sony in 1946 and since then they were working to develop a color TV set. To get more ideas on the product, they both flew and attended a trade show in New York. At the show, they viewed a brightest and sharpest image on a colour TV screen which they had never seen before, called the Chromatron. Wasting no time, Morita negotiated a technical licence from the developer (which is Autometric Lab, subsidiary of Paramount Picture) to produce a color television received designed around the Chromatron tube. It took two years of effort for Ibuka to led the project and by September 1964, they succeeded in developing a prototype an announced it to the public.

Ibuka was very optimistic and confident about this product. Due to massive reactions and response from the consumers, Sony invested in a new facility to house the Chomatron assembly, placed 150 people on its assembly line and make this product as their main priority. The retail price of the product was $550 but the cost of production cost double more double than that amount. Realizing that they were actually making losses, Morita decided to end this project but denied by Ibuka. Sony therefore continued producing and selling to almost 13,000 sets, each one with a negative unit gross margin. When their financial managers announced that they were ‘close to ruin’, only then Ibuka agree to terminate the Chomatron project.

From this case, clearly shows that there were two behavioural elements at work which are overconfidence and loss aversion. Ibuka was overconfidence in committing Sony to mass-produce the product before his engineers had the chance to develop a cost-effective mass production process. Refusing to accept the fact that the product is a sure loss, Ibuka remains confident and continued to invest in the project, preferring the gamble that a solution could be worked out (loss aversion).

The failure in the incentive systems has forced managers to make suboptimal corporate decisions and that has become major issues in the agency theory. In the Sony case, Ibuka even being rewarded as Sony’s major shareholder did not prevent him from succumbing to overconfidence or loss aversion in his actions as a manager. No doubt that incentives plays an important role, but from Sony’ case it clearly indicates that incentives effects by themselves will not necessarily overcome the impact of behavioural elements.

Amer Azlan

The aboved article is part of summary of research paper written by Hersh Shefrin (1999) from Santa Clara University.


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