NBER WORKING PAPER SERIES BEHAVIORAL CORPORATE FINANCE Ulrike Malmendier Working Paper 25162 http://www.nber.org/papers/w25162 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2018 I thank Alexandra Steiny, Marius Guenzel, and Woojin Kim for excellent research assistance. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2018 by Ulrike Malmendier. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Behavioral Corporate Finance Ulrike Malmendier NBER Working Paper No. 25162 October 2018 JEL No. G02,G3,G4 ABSTRACT Behavioral Corporate Finance provides new and testable explanations for long-standing corporate-finance puzzles by applying insights from psychology to the behavior of investors, managers, and third parties (e. g., analysts or bankers). This chapter gives an overview of the three leading streams of research and quantifies publication output and trends in the field. It emphasizes how Behavioral Corporate Finance has contributed to the broader field of Behavioral Economics. One contribution arises from the identification of biased behavior (also) in successful professionals, such as CEOs, entrepreneurs, or analysts. This evidence constitutes a significant departure from the prior focus on individual investors and consumers, where biases could be interpreted as `low ability,' and it implies much broader applicability and implications of behavioral biases. A related contribution is the emphasis on individual heterogeneity, i. e., the careful consideration of the type of biases that are plausible for which type of individual and situation. Ulrike Malmendier Department of Economics 549 Evans Hall # 3880 University of California, Berkeley Berkeley, CA 94720-3880 and NBER [email protected] Contents 1 Introduction 1 2 Three Perspectives3 2.1 Corporate Finance and Behavioral Corporate Finance.................3 2.2 Perspective 1: Biased Investors..............................6 2.3 Perspective 2: Biased Managers..............................9 2.4 Perspective 3: Biased Third Parties............................ 11 2.5 Which Perspective is Right?................................ 12 2.6 Where Do We Stand?|Quantifying Behavioral Corporate Research......... 13 3 An Illustration: Theory and Empirics of M&A 19 3.1 Stylized Facts........................................ 19 3.2 Biased Investors...................................... 23 3.2.1 Model and Predictions............................... 24 3.2.2 Empirical Evidence................................. 27 3.3 Biased Managers...................................... 33 3.3.1 Model and Predictions............................... 33 3.3.2 Empirical Evidence................................. 38 3.4 Biased Investors and Biased Managers.......................... 52 4 Key Areas of Research 54 4.1 Corporate Response to Biased Investors and Analysts................. 55 4.1.1 Timing non-rational investor beliefs....................... 55 4.1.2 Catering to non-standard investor demand.................... 59 4.1.3 Media, Attention, and Information........................ 62 4.2 Biased Managers...................................... 65 4.2.1 Overconfidence................................... 65 4.2.2 Other Managerial Biases and Characteristics.................. 73 4.3 Networks.......................................... 80 5 Past and Future Developments, Open Questions, and Conclusion 86 References 90 A Supplementary Material on Quantification of Behavioral Corporate Finance Re- search 105 2 A.1 Identification of Relevant Research Areas........................ 105 A.2 Quantification of Papers by Field and Journal...................... 109 A.3 Detailed Summary Statistics................................ 114 B Supplementary Material on Theory and Empirics of Mergers and Acquisitions 115 B.1 Additional Figures on Stylized Facts on M&A...................... 115 B.2 Additional Figures and Tables on Model and Empirics of Merger Example...... 116 1 Introduction The field of Corporate Finance might well be the area of economic research with the most misleading name (followed by Behavioral Economics as a close second). Many of the research papers identified as \Corporate Finance" deal neither with corporations nor with financing decisions. In this chapter of the Handbook, I first conceptualize the breadth and boundaries of Corporate Finance research, and then present the advances that have resulted from applying insights from psychology. I illustrate how the behavioral toolbox has allowed for progress on long-standing puzzles regarding corporate investment, mergers and acquisitions, and corporate financing choices. Naturally, this enterprise entails discussing the key research questions and developments in the field of Behavioral Corporate Finance. However, the most important contribution of Behavioral Corporate Finance might well go beyond the concrete applications of insights from psychology to corporate-finance puzzles. Research in Behavioral Corporate has been critical to the development of Behavioral Economics in that it was the first to apply behavioral assumptions not just to in- dividual consumers or small investors, but show that the behavioral framework is crucial for our understanding of the decision-making of smart and highly trained professionals who lead large or- ganizations. Even corporate leaders systematically deviate from our standard neoclassical model of rational decision-making and exhibit, for example, anchoring bias, loss aversion, and overconfidence when they make far-reaching corporate decisions. This step constituted a sharp departure from the emphasis in much of the prior behavioral research, which had focused on individuals outside the realm of their professional lives and train- ing. Bad consumption choices, ill-informed personal investment choices, biased expectations about variables the individual is not educated to assess (such as future interest rates), and similar ap- plications tended to be the focus of the existing theoretical and empirical research.1 Corporate Finance researchers have been among the first to argue theoretically and show empirically that top managers and professionals are subject to systematic biases. As such, they have altered the view on what the behavioral toolbox is able to do and why it is important to add psychological realism also to our models of top-level decision making. Two more general insights have emerged from Behavioral Corporate Finance research on high- level decision-makers. First, the evidence on biased behavior of smart and talented professionals implies that successful “fixes” of biased decision-making will need to be of a different nature than 1A notable exception is the study of professional baseball executives, as discussed in Lewis' intriguing book \Moneyball" (Lewis 2004) and analyzed more rigorously by Thaler and Sunstein (2003). They conclude that \the blunders of many [baseball executives] suggests the persistence of boundedly rational behavior in a domain in which market pressures might well have been expected to eliminate them." Relatedly, Romer (2006) analyzes the choice on fourth down in the National Football League, and provides evidence of systematic departures from the decisions that would maximize the chances of winning. Massey and Thaler (2013) study the annual player draft in the NFL and show that the professional scouts persistently overvalue top draft picks. 1 implied by the earlier emphasis on education and financial literacy. For widespread deviations from the standard rational model, such as overconfidence, for example, cognitive limitations are unlikely to be the root and explanations unlikely to be the remedy. Second, behavioral researchers should consider carefully which biases are plausible for which individual in which setting, rather than testing them uniformly in their \convenience sample." Being confronted with the objection that \successful CEOs surely won't be biased," or concerns about the seeming inconsistency of considering investor biases in one paper and managerial biases in another, researchers in Behavioral Corporate Finance had to think hard about the type of biases that are plausible for decision-makers in a corporate setting and how they differ from those consid- ered for the untrained individual. For example, psychological research provides ample motivating evidence to test for managerial overconfidence, but less for underconfidence or cognitive limitations that might be relevant for research in household finance. This focus on specific biases for specific settings is a perspective that is now percolating into other fields of Behavioral Economics.2 This handbook article presents the existing research and open questions in the field of Behavioral Corporate Finance with the intention of fostering its development and influence on the broader field, as well as inspiring further research along these lines. In the following pages, I first present a general introduction to research in Behavioral Corporate Finance (Section2). I distinguish between two main \perspectives:" research on individual investor biases (and managers' response), and research on managerial