In rational decision making by investors and financial managers, the decisions are aimed towards maximizing portfolio or company value while analyzing relevant information for rational, objective and risk-neutral decision.
However, there are influences of psychology on the behaviour of investors and financial managers as financial decision makers, which has an impact on their decisions leading towards unpredictable consequences.
Behavioural finance explains how financial decision makers take financial decisions in real life, which lead to irrational decisions sometime with unpredictable consequences.
| Factors | Investors | Finance Managers |
|---|---|---|
| Maximization of utility | Basic aim of investors decisions are to maximize their long-term wealth. However…. (1) Investors may have preferences for particular companies based on non-financial grounds even the shares are not performing well, e.g. acting with social responsibility, ecological factors, or cultural factors etc. (2) Cognitive dissonance: Investors sometime keep holding shares with prices that have fallen over time and are unlikely to recover. Investors may do this because it will cause them psychological hurt to admit that their decision to invest was wrong in past. | Basic aim of finance managers decisions are to maximize company’s value. However….. (1) Agency theory provides that managers may have different objectives from shareholders, such as maximizing their own short-term rewards, e.g., expanding the company by acquisition towards empire building ignoring better organic growth opportunities. (2) Loss aversion bias: At contested takeovers, where different companies bidding against each other has forced the acquisition price up to a level that was significantly higher than actual value of the target company. Sometime managers enter into competitive takeover bids to get a source of satisfaction that others have sought to buy as well and an unwilling to let someone else have what they have been trying to acquire. |
| Analysis of relevant information | (1) Anchoring: Investors may use information that is not relevant but is readily available, possibly to simplify the decision-making process. (2) Law of averages: It is a believe in investors that the probability of a future outcome is based on how often the same outcome has occurred in the past. (e.g. a coin is flipped ten times, comes up as tails every time and it is said that heads is more likely the eleventh time as, by the ‘law of averages’, heads must come up soon). (3) Gambler’s fallacy: After following a trend of prolonged rise in company’s shares, investors may sell those shares assuming that the shares have gained in value for ‘long enough’ and their price must therefore soon start to fall, even if rational analysis suggest that the rise in price will continue. (4) Herd instinct: Explanations for investors following a herd instinct include social conformity, the desire not to act differently from others. E.g. everybody buying technology sector shares leading to stock market bubble. (5) Noise traders: In some situations, investment decisions are not based on rational analysis. E.g. making poorly timed decisions and following trends. (6) Small capitalization discount: Investors ignore companies with low market capitalization, as a result their shares never been purchased and their value remains low. | (1) In a takeover decision making process, not making a rational assessment of the target company’s potential resulting into imperfect analysis of information. E.g., financial managers arguing that the target company should be valued not using its own PE ratio, but using the (higher) PE ratio of the acquirer. (2) Entrapment: Many situations finance managers may feel that a failing strategy would damage their reputation not only within the company but also outside, and possibly their future prospects in the corporate career. Hence, the may spend more funds trying to ensure that the strategy is successful, rather than admitting defeat and taking steps to mitigate losses in the best interest of shareholders. (3) Creative accounting: Finance managers to achieve their short-term rewards related to profitability or share price may take steps towards creative accounting affecting published financials which would artificially boost the share price. |
| Rational, objective and risk-neutral analysis | (1) Confirmation bias: There are instances where an investor while investing into an equity, pays attention to evidence that confirms investors’ current beliefs about their investments and ignoring evidence that casts doubt on their beliefs. E.g. in the dotcom boom (bubble) in US stock market back in year 2000, some investors used a variety of methods to value high-tech companies at a large premium, but ignored models such as cash flow valuation models that indicated the worth of those companies was much lower. (2) Taking a different attitudes towards the risks of making profits as compared to rational risk theory, e.g. risk-neutral investor taking risk for high profit. (3) Regret aversion: Sometimes investors avoiding investments saying that it has the risk of making losses, but value analysis may suggests of long-term capital gains. (4) Sometime investors pay most attention to the last set of financial results and other recent information about a company, while ignoring past track record and future prospects. (5) Momentum effect in capital markets: After a prolonged period of rising share prices & indices may result in a general feeling of optimism in the capital market that price rises will continue and an increased willingness to invest in such companies. Such momentum effect will result in a prolonged period of stock market boom or bust. | (1) Considerable bias: During merger & acquisition decisions, the finance managers in many instances pay attention to information that suggests that an acquisition will enhance the acquisition company’s value and ignoring evidences that indicates that the target company will not be a good buy. The finance managers sometime consider information that provides a simple yardstick for their own decision making, but these informations may have serious imperfections. During merger & acquisition the value that finance mangers put on the target company may be subject to considerable bias. (2) Empire building: growing by takeovers not by improving ROCE (return on capital employeed) through organic growth. |
Lastly, many critics of behavioural finance provides that these irrational decisions are short-term anomalies helping investors & finance managers to learn from their experiences and in long-run efficient market hypothesis will apply.
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