Chapter One Behavioral Foundations Chapter

Chapter One Chapter One Behavioral Foundations The main objective of this chapter is for students to demonstrate that they can de- scribe 10 specific psychological phenomena that impact the judgments and choices that normal people make about decision tasks that feature risk. These phenomena areBehavioral divided into two groups: heuristics andFoundations biases, and framing effects. After completing this chapter students will be able to: The main objective of this chapter is for students to demonstrate that they can de- scribe1. Identify 10 specific key biases psychological that typically phenomenaarise when people that impact make thejudgments judgments about and risk. choices that2. Explain normal why people reliance make on heuristics,about decision while unavoidable,tasks that feature leaves risk. people These vulnerable phenomena to aremaking divided biased into two judgments. groups: heuristics and biases, and framing effects. After3. Recognize completing that this framing chapter effects students lead willpeople’s be able attitudes to: toward taking risk to be highly dependent on the circumstances in which they find themselves. 1. Identify key biases that typically arise when people make judgments about risk. 2. Explain why reliance on heuristics, while unavoidable, leaves people vulnerable to 1.1 TRADITIONAL makingCORPORATE biased judgments. FINANCIAL DECISIONS AND PSYCHOLOGICAL3. Recognize that TASKS framing effects lead people’s attitudes toward taking risk to be highly dependent on the circumstances in which they find themselves. A wealth of psychological research over the last 50 years provides important in- 1.1 TRADITIONALsights CORPORATE into how normal FINANCIAL people make judgments DECISIONS and choices about risky alterna- tives. Over the same period, research conducted by financial academics provides AND PSYCHOLOGICALimportant insights TASKS into how financial executives should consider making judgments and decisions about corporate risk, and to some extent what executives do in prac- tice.A wealth This ofbook psychological will help you research to connect over thethese last two 50 researchyears provides streams, important and in thein- coursesights intoof doing how sonormal it will people provide make you withjudgments insights and about choices the degree about torisky which alterna- psy- chologicaltives. Over pitfalls the same create period, imperfections research conductedin corporate by decision financial making academics and reductions provides inimportant corporate insights value. into The how book financial will also executives provide guidance should consider about how making to create judgments value byand mitigating decisions vulnerabilityabout corporate to theserisk, andpitfalls. to some extent what executives do in prac- tice.To This help book fix ideas, will helpconsider you ato small connect example. these Imaginetwo research a firm streams, is contemplating and in the a newcourse one-year of doing project so it willwhich provide requires you it withto spend insights $3.2 about million the at degree the end to ofwhich this year,psy- inchological the anticipation pitfalls createof receiving imperfections a return inat corporatethe end of decision the following making year. and The reductions project isin cyclical,corporate as value. the financial The book executives will also at provide the firm guidance believe thatabout the how actual to createvalue ofvalue the futureby mitigating cash flow vulnerability from the project to these will pitfalls. strongly depend on the state of the economy duringTo help the nextfix ideas, year. Theconsider project a small also featuresexample. high Imagine risk, asa firmcash isflow contemplating will be espe a- ciallynew one-year high if the project economy which is requiresstrong but it toespecially spend $3.2 low million if the economy at the end is ofweak. this Typiyear,- cally,in the foranticipation projects of of comparable receiving a risk, return the at firm the seeksend of an the expected following return year. of The35 percent. project is cyclical, as the financial executives at the firm believe that the actual value of the1 future cash flow from the project will strongly depend on the state of the economy during the next year. The project also features high risk, as cash flow will be especially high if the economy is strong but especially low if the economy is weak. Typi- cally, for projects of comparable risk, the firm seeks an expected return of 35 percent. 1 she77208_ch01_001-031.indd 1 2/7/17 5:25 PM she77208_ch01_001-031.indd 1 2/7/17 5:25 PM 2 Chapter One Behavioral Foundations 3 Suppose that the economy was stagnant last year, and that economists’ current $3.4 million. Notably, $3.4 million exceeds the $3.2 million required capital investment, outlook for next year is that there is a very high chance that growth will continue which according to traditional textbook analysis suggests that the financial executives 2 Chapter One to be stagnant. Suppose too that most economists agree that there is a low chance should adopt the project. of moderate growth and a very low chance of a boom. The consensus view is that There are two important psychological points to note in the example. The first a Supposerecession that is thenot economylikely, but was if stagnantone materializes last year, andit is that half economists’ as likely to current be severe point pertains to the fact that the financial executives were not given quantitative prob- outlookas mild. for next year is that there is a very high chance that growth will continue abilities, but instead had to make their own subjective judgments about what numbers to beThe stagnant. financial Suppose executives too that typically most economists rely on these agree forecasts that there to form is a lowtheir chance own judg- to use, based on a mix of qualitative and quantitative information available to them. ofments, moderate which growth they andcombine a very with low otherchance information of a boom. such The asconsensus recent stock view market is that per- Notice from Exhibit 1-1 that executives assign a probability of 6 percent to a boom, a formance.recession isIn notthis likely, regard, but the if stockone materializes market increased it is half by as25 likelypercent to duringbe severe the last which is much higher than the 1 percent they assign to low-to-moderate growth. Given as mild.twelve months, the stock of the average firm in their industry increased by 18 per- that economists characterized low-to-moderate growth as being more likely than a cent,The andfinancial the stock executives of their typically own firm rely increased on these byforecasts 12 percent. to form their own judg- boom, financial executives’ probability assignment might reflect judgmental biases ments,In assessingwhich they their combine proposed with other project, information the executives such as estimaterecent stock that market its cash per- flows or a psychological tendency to overweight probabilities of extreme events. A similar formance.will be $46.9 In this million regard, in thethe stockevent market of a boom, increased $31.9 by million 25 percent if the during economy the exhibitslast remark applies to the probabilities that executives assign to a recession. twelvemoderate months, growth, the stock$1.9 ofmillion the average if the economyfirm in their is stagnant,industry increased−$8 million by 18in per-the case The second point concerns the gains and losses associated with the project, where cent,of a andmild the recession, stock of theirand −$13own firm in the increased case of bya severe 12 percent. recession. the gain is expressed as “payback” defined as cash flow minus initial investment. InPut assessing yourself their in the proposed position project, of a financial the executives executive estimate who has that the its responsibility cash flows of See the rightmost column in Exhibit 1-1. Notice that the probability of the project willdeciding be $46.9 whether million to in adopt the event this ofproject. a boom, Suppose $31.9 millionthat you if placethe economy a lot of exhibits trust in the incurring a loss is 93 percent, with gains being generated if the economy grows. moderatecash flow growth, estimates, $1.9 asmillion well ifas the in theeconomy economists’ is stagnant, general −$8 assessment. million in the Would case you Psychologically, being super sensitive to losses might lead the executives to reject offeel a mild that recession,you have enoughand −$13 information in the case toof makea severe an recession.informed decision about whether the project, despite its positive net present value. toPut adopt yourself the project? in the position of a financial executive who has the responsibility of The two points just mentioned relate to the primary focus of this chapter, whose decidingThe standardwhether totextbook adopt this approach project. to Suppose project selectionthat you place revolves a lot around of trust discounted in the purpose is to introduce ten specific psychological phenomena that underlie the be- cashexpected flow estimates,cash flows. as Inwell theory, as in the economists’computation general of expected assessment. cash flows Would would you re- havioral approach to corporate finance. To be sure, there are other psychological feelquire that quantitative you have enough probabilities information for the to makealternative an informed states ofdecision the economy, about whether not simply phenomena discussed in the book, besides the ones introduced in this chapter.

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