Behavioral Finance and Corporate Decision-Making

Financial decision making processes have been proven to involve more than calculative, cold agents through the presence of anomalies such as overreaction, speculative bubbles and under reactions to new information in the market. Decisions made can end up being irrational and inefficient, resulting in stock market disasters since the investors are humans who can be influenced by emotions. Behavioral finance has been driven by the need to understand stock market anomalies as well as human judgment shortcomings. It deals with how psychology influences the behavior of financial practitioners and the resulting stock markets impacts. Unlike traditional finance paradigms which comprehend financial markets through models where the agents are rational, behavioral finance argues that investors do not operate as fully rational decision makers (Nigam, Srivastava and Banwet, 2018). It asserts that traditional finance models are not complete as they do not take into consideration individual behavior which influences the rational paradigm of the investor as well as the resulting investment choices.

In mainstream finance, greater currency is being given to the insight of how psychology affects corporations, financial decisions as well as financial markets. Time and again researchers highlight that investor irrationality is an inevitable reality with many results concluding that many changes in investment decisions are due to behavioral biases (Chhapra et al. 2018). The rationality assumption present in traditional finance is relaxed in behavioral finance as real investors in the real world are influenced by their psychological biases. Biases get translated into behavior through which suboptimal decisions are made (Kapoor and Prosad, 2017). Through behavioral finance, various theories regarding the behavior of the investors have been proposed in explaining the factors that affect their decisions in the stock market. They include the regret theory, theory of overconfidence, under or overreacting theory, herding theory, and risk perception. In making investment decisions, fear of regret can make investors take high risk levels or make them risk averse (Alquraan, Alqisie, and Shorafa, 2016). The regret theory involves emotional reactions the investors experience after coming to the realization that they made an error in their decisions and evaluations. It holds true for those who made a bad investment as well as those who find a stock they considered buying but did not went up in value. To avoid feeling this regret, many investors choose to follow conventional wisdoms like only buying stocks that everyone else is buying (Jagongo and Mutswenje, 2014).

Abnormal changes in share prices have been described as a manifestation of overreaction to any information while stock market reactions to the information even in subsequent time periods is deemed as an under reaction. Behavioral constructs have been identified in various studies as the causes of rationalizing over reacting and underreacting among investors and this includes being overly optimistic, personality traits, conservative and representative heuristics, as well as attention grabbing events (Yuan, 2015).

How behavioral finance can be applied in the context of corporate finance- linking the behavioral characteristics of top executives and their decision making.

Behavioral finance aims at understanding and predicting systematic market implications involving economic as well as psychological principles with the aim of improving financial decision making. It provides insight on how psychology affects corporations, financial decisions as well as financial markets. Behavioral finance can shed considerable light on the erratic and unpredictable nature of human behavior as well as the role of the top executives in their decision making processes that are also subject to cognitive ability and human rationality (Dittenhofer, 2001). It emphasizes that the top executive does not operate in a vacuum in the corporates but are involved in financial systems that are designed, created, and operated by people and therefore behavioral aspects need to be considered in decision making. Through the analysis of the relationship between the financial or accounting system, human attitudes, other forms of control as well as decisions, behavioral finance focuses the attention of the top executive on the underlying contradictions and conflicts as well as the corporation’s potential.

General insights emerging from behavioral finance for high level decision makers point out that there is need for different fixes for biased decision making from biased behaviors of talented and smart professionals than that of traditional methods which involved emphasis on financial literacy and education (Malmendier, 2018). Behavioral finance also sheds light on the type of biases that are plausible for certain individuals in particular settings. Biases that are plausible for decision makers in corporate settings have to be considered side by side with managerial as well as investor biases and how they are different from those of the untrained individual. The perspective of the biased investor provides a natural starting point for behavioral finance in the corporate world as it allows a departure from the notion of smart managers dealing with dumb investors as it might be the executives behaving in biased manners.

References

Alquraan, T., Alqisie, A., & Shorafa, A. A. (2016). Do behavioral finance factors influence stock investment decisions of individual investors?(Evidences from Saudi Stock Market). American international journal of contemporary research, 6(3), 159-169.

Chhapra, I. U., Kashif, M., Rehan, R., & Bai, A. (2018). An empirical investigation of investors behavioral biases on financial decision making. Asian Journal of Empirical Research, 8(3), 99-109.

Dittenhofer, M. A. (2001). Behavioral aspects of government financial management. Managerial Auditing Journal.

Jagongo, A., & Mutswenje, V. S. (2014). A survey of the factors influencing investment decisions: the case of individual investors at the NSE. International Journal of Humanities and Social Science, 4(4), 92-102.

Kapoor, S., & Prosad, J. M. (2017). Behavioural finance: A review. Procedia computer science, 122, 50-54.

Malmendier, U. (2018). Behavioral corporate finance. In Handbook of Behavioral Economics: Applications and Foundations 1 (Vol. 1, pp. 277-379). North-Holland.

Nigam, R. M., Srivastava, S., & Banwet, D. K. (2018). Behavioral mediators of financial decision making–a state-of-art literature review. Review of Behavioral Finance.

Yuan, Y. (2015). Market-wide attention, trading, and stock returns. Journal of Financial Economics, 116(3), 548-564.