Adam, Burg, Scheinert, and Streitz show that overconfident managers are more likely to issue rate-increasing performance-pricing provisions in loan contracts than regular debt. In addition, Landier and Thesmar examine the effects of managerial optimism on financial contracting. They show that optimistic managers self-select into short-term debt and rational managers into long-term debt.
Hackbarth incorporates optimism and overconfidence into a model of capital structure to study the impact on corporate financial policy. Optimistic as well as overconfident managers choose higher debt levels and issue debt more often. Malmendier et al. For example, overconfident managers use less external finance and, conditional on accessing external capital, issue less equity than their peers.
Cronqvist et al. Similarly, Hutton, Jiang, and Kumar detect that CEOs who exhibit conservative personal ideologies, that is, certain preferences for conservative political parties, follow conservative rather than aggressive financial policies. CEOs may self-select into companies that fit their preferences, and thus unobservable standard factors may determine capital structure decisions, which causes endogeneity concerns regarding the outlined behavioral explanations.
To address this, Malmendier et al. The authors find support for a causal relation. For example, CEOs who grew up during the Great Depression exhibit less trust and faith in capital markets and thus prefer internal over external funds. These CEOs behave more conservatively and underutilize leverage relative to optimal levels.
Equivalently, Feng and Johansson provide empirical evidence that firms managed by CEOs who were exposed to a traumatic experience during childhood, for example, the Great Famine in China, have more conservative policies such as lower leverage. Schoar and Zuo focus on adulthood experiences, which also shape the decisions of CEOs.
For example, managers who start their career during economic recessions exhibit lower levels of leverage compared to non-recession CEOs. In contrast, CEOs who served in the military, especially those with combat or war experience, behave less conservatively and choose higher leverage ratios e. Employing a broader sample, Benmelech and Frydman find that military CEOs prefer lower leverage.
Bernile et al. By examining the degree to which CEOs were exposed to natural disasters e. CEOs highly exposed to natural disasters prefer a capital structure with lower debt proportion. Ahmed and Duellman and Hribar and Yang study overconfident CEOs and show that such CEOs exhibit more aggressive earnings forecast disclosures and less conservative accounting policies.
Also, if executives own luxury goods or have legal records, they are more likely to conduct misreporting, or even corporate fraud, during their tenure. In contrast, CEOs who grew up as more frugal, that is, being exposed to the Great Famine in China, exhibit a reduced likelihood of unethical behavior e.
Several situational factors, that is, the context in which a human is located, affect behavior in the short term. For example, acute situations can influence the emotional state i. As behavior is observed in an environmental context, it must not be consistent across situations or time but rather related to a specific domain or task e. For example, Mannor, Wowak, and Bartkus interview CEOs and find that managers who exhibit job-related anxiety take fewer strategic risks compared to their less stressed peers.
Chhaochharia, Kim, Korniotis, and Kumar examine how managerial mood affects capital expenditures. They find that managers exhibit more optimistic expectations if they operate in favorable situations, that is, sunny periods, which has a persistent effect with regard to investments. The authors argue that it takes relatively long to debias such mood-induced expectations as small business managers are not exposed to a market containing rational shareholders they can learn from or listen to e.
Malmendier and Tate examine shifts in CEO status through prominent business awards and find that firms who are managed by media-induced superstar CEOs exhibit inferior stock and operating performance. Due to private and professional distractions, managers may find it especially challenging to meet or exceed market expectations and therefore engage in active earnings management. Indeed, managers start to artificially increase earnings relative to their pre-superstar status and current peers in order to maintain their success and to not receive negative attention for their inferior performance.
However, the superstar CEOs cannot sustain this in the long term, and eventually negative earnings are reported. Simon suggests a behavioral model of human decision making, arguing that information acquisition, time, and cognitive costs result in bounded rationality and thereby biases. These mental shortcuts are summarized under behavioral activities.
In this vein, Ljungqvist and Wilhelm show that CEOs with more experience are less likely to exhibit behavioral biases when choosing their IPO underwriters. Based on prior literature, the authors argue that executives use a firm-wide discount rate instead of making risk-adjusted investment decisions, and therefore managers of conglomerate firms underinvest overinvest in relatively safe risky divisions e.
The application of such a heuristic decreases with time as financial innovation increases, and as a consequence more sophisticated discount rates are used by managers. Kim focuses on the personal activity directly and analyzes managers with biased self-attribution, that is, crediting their own ability for successes and blaming external factors for failures, which can also reinforce overconfidence in decision making e.
The author studies CEO interviews on CNBC and examines how often they reference themselves versus the economy when explaining reasons for failures. Doukas and Petmezas exploit the time series of multiple acquisitions and argue that a self-attribution bias is prevalent if managers engage in further acquisitions after completing successful deals. They find that managers tend to credit the initial success to their own ability and therefore become overconfident and engage in more deals.
Risk Management. Adam, Fernando, and Golubeva use a unique data set of corporate derivatives positions and show that managers increase their speculative activities using derivatives following speculative cash flow gains, while they do not reduce their speculative activities following speculative losses. This asymmetric response is consistent with the selective self-attribution associated with overconfidence. Humans recognize salient events faster and easier, and therefore may become prone to an availability heuristic e.
Indeed, the authors show that managers overreact to the salience of risk if hurricanes hit neighboring areas. As a result, managers temporarily increase their corporate cash holdings as well as emphasize their risk concerns by mentioning hurricane threats in company filings. So far, only one of the actors in this behavioral principal-agent framework was assumed to be human. In reality, both actors may exhibit non-standard beliefs or preferences see, e. One possibility to address this is to use a behavioral finance approach that does not focus on the non-standard behavior of certain parties, for example, behavioral states or traits, but instead on the deviations from standard predictions, that is, the detection of anomalies e.
This direct approach is often applied when examining behavioral activities. Offer premiums are based on prior peak prices that serve as anchors. If target premiums exceed historical peaks, acquirer shareholders react negatively at deal announcement and target shareholders are more willing to accept the offer. Baker and Wurgler emphasize that in this scenario both actors may be prone to reference dependent biases. Theoretical models can also be valuable in examining less than fully rational principals and agents.
One starting point for further research is the behavioral signaling theory introduced by Baker, Ruback, and Wurgler , which is based on less rational managers as well as quasi-rational shareholders and therefore captures a broader range of implications. Figure 3 illustrates the coexistence of behavioral principals and behavioral agents. For example, if shareholders undervalue the company, overly optimistic managers may engage in excessive share repurchases which would distort firm value Action A1.
Thus, behavioral principals and agents distort investments to a greater degree than if only one of the two actors would exhibit non-standard behavior Actions A2 and A3. Figure 3. Behavioral principals versus behavioral agents and firm value own illustration. However, if the behavior is not directly observable, sociological factors are valuable in explaining behavior indirectly, for example, uncovering potential behavioral distortions within a social environment.
In specific, a social environment is characterized by the presence of other individuals or groups, who create social channels, define processes, and make decisions. For example, Lewin describes social channels as definite formalized social systems, which contain established beliefs and values hereafter social traits. In such systems, social processes, the ways of interaction between individuals in a particular situation, can be located. Social processes, to which interacting individuals are jointly exposed, can be changed and readjusted through social interactions hereafter social states.
Therefore, in social environments direct or indirect communication between subjects is an essential medium. Figure 4 illustrates the extension of the behavioral principal-agent framework toward a social approach. Thus, actors, that is, standard or behavioral principals and agents, are not isolated from others but take a social position within or across different environments. Importantly, not all sociological determinants result in biased outcomes.
In the following section, social corporate finance constructs are presented, and how socialization i. Figure 4. Social and behavioral principal-agent frameworks own illustration. Social traits, like behavioral traits, are relatively stable. Individuals exhibit similar social traits if they belong to a similar organized institution. The most prominent social trait is culture, which is defined as a set of shared norms and values within a system that unifies individuals in social structures e.
For example, Weld, Michaely, Thaler, and Benartzi document that nominal share prices remain at a low levels since the s even though it is costly for shareholders. The main challenge in finance research is to operationalize the latent construct culture.
While some studies analyze culture at the geographical level, others characterize it at the firm or individual level. In addition, cultural differences between countries lead to low cross-border deal volumes as the probability for cultural clashes and integration costs increase e. Local measures of culture and social capital, for example, religiosity or gambling attitudes, are also used to capture social norms. In contrast, CEOs of companies located in areas with high propensities to gamble overvalue and invest into projects with high skewness, which is detrimental to shareholder wealth e.
For example, studies measure ethics and competition versus creation-oriented cultures from company-specific texts such as annual reports e. Others, like Tate and Yang and Guiso et al. Also, Tian and Wang analyze tolerance for failure of venture capitalists and show that a culture with strong tolerance for failure results in increased start-up innovation. The authors exploit shocks to the banking industry to eliminate issues stemming from endogenous CEO to firm matching. Social states can shape a reduced way of thinking and lead to cognitive or spatial limits.
In this case, corporate social finance can be particularity valuable to understand the behavior of principals and agents. Making social inferences from cultural differences is one approach—for example, how to identify the exact psychological source of suboptimal behavior e. For example, Hirshleifer et al. Without this specific social setting, they would not be able to find non-standard behavior stemming from superstitious beliefs.
Social states comprise social processes between individuals. In a social process, individuals are in the same state, that is, being exposed to similar circumstances. As social states are an artifact of a particular period of time, they can either evolve, change, or dissolve e. Recent developments with regard to social states are found in the nature, causes, and effects of trust in interpersonal relationships.
While trust can be a beneficial source of efficiency, Audi, Loughran, and McDonald show that companies that exhibit a trusting corporate culture also increase their efforts to control and verify information toward outside shareholders. Thus, in a corporate context it depends on the situation and state whether or not formal rules, contracts, or other legalistic mechanisms serve as a facilitator or blockade in restoring trust e.
As environments change, social states are an interesting venue for corporate finance research, especially when organizations maneuver in times of instability. In order to respond appropriately to dynamic social situations, individuals need an accurate perception of reality to prevent behavioral distortions e. For example, CEOs with strong levels of job anxiety support hires of trusted friends as chief operating officers COOs because they serve as social buffers when facing difficult decisions e.
Social activities synthesize managerial assessments and decision-making actions, in the presence of other individuals or groups. Hirshleifer and Teoh refer to this as a social transmission bias, that is, how ideas spread and evolve to be appealing to a group even though they would not be considered as catchy by an individual in a vacuum. For example, Jochem and Peters show that managerial optimism is transmitted to other firms through customer-supplier networks and suggest that such a transmission bias can even impact business cycle fluctuations.
The main social activity is the mimicking or herding behavior of managers or companies toward peer groups. Managers observe and follow their local peers with a biased mind, for example, an overattribution to common thinking or local information, so that investments and financing distortions arise e.
Hence, if managers interact within homogeneous networks, the homophily of social interactions can slow down or even prevent the convergence of good practices among corporations e. Adhikari and Agrawal and Leary and Roberts use a conventional approach to identify peers and create similar firm groups based on industry affiliation.
This behavior is found to be prevalent among smaller, less successful, and financially constrained firms as well as in markets with high product competition, which is consistent with a rivalry-based theory of imitation. Another classical approach is to use managerial compensation peers as a reference group.
However, Bizjak, Lemmon, and Nguyen show that firms have incentives to choose peers that inflate executive pay, so compensation peers do not necessarily reflect the true peer group. This product similarity measure outperforms conventional industry-based measures since it captures that firms may operate in several product markets despite belonging to a specific industry.
They show that superstar CEOs have a positive welfare impact on their peers, especially when award winners are geographically close. Peer superstars take more risks and innovate to a greater extent. Gomes, Gopalan, Leary, and Marcet compare analyst as well as industry measures and confirm a mimicking behavior in firm leverage.
For example, Fracassi identifies social peers by examining private and professional social ties, for example, connections from current and past employment, education, as well as leisure activities. The author finds that managers who share social connections with each other exhibit similar capital investment decisions. However, the deals are characterized by significantly negative abnormal returns for the acquirer as well as for the combined corporation.
Similarly, Chikh and Filbien focus on French networks and find that well-connected CEOs are less likely to listen to the market and thus complete deals for which market reaction is unfavorable. A study by Jaspersen and Limbach investigates demographic similarity between fund managers as well as CEOs and finds that fund managers overweight firms run by CEOs who possess resembling features, for example, age, ethnicity, and gender.
Managerial envy defined as a mixture of emotions triggered by a self-comparison with another person or other groups who possess desired attributes and make one feel inferior is also related to social activities e. In their theoretical models, Becker and Goel and Thakor , introduce envy as a driver for investment distortions and merger waves. Social peers or ties can also be seen as strategic in terms of individuals behaving rationally to take advantage of their social connections to get access to superior information at lower cost or just because the social penalty of distancing themselves from social networks is too costly e.
Social networks and peer effects allow researchers to link inferior decision making to behavioral distortions without directly observing the underlying psychological bias. This article summarizes the currently existing academic research on behavioral and social corporate finance.
First, a behavioral principal and agent framework is introduced, which systematically categorizes and differentiates between rational and behavioral decision makers. Second, a social principal and agent view is proposed as actors do not make decisions in a vacuum but rather behave de-isolated in a dynamic social environment.
The presence of behavioral shareholders leads to market timing and catering behavior by rational managers. Specifically, such managers will opportunistically time the market and exploit mispricing by investing capital, issuing securities, or borrowing debt when costs of capital are low and shunning equity, divesting assets, repurchasing securities, and paying back debt when costs of capital are high. If prices deviate from their fundamental values, they can be exploited and shifted at the same time, so an important goal for future research is to quantify the interactive effect between market timing and catering.
The interaction of behavioral managers with rational shareholders also leads to distortions in corporate decision making. For example, managers perceive fundamental values differently and systematically diverge from optimal decisions.
These factors can bias the value perception by managers and thus lead to inferior decision making. Which behavioral aspects, that is, traits, states, and activities, contribute the most to managerial distortions remains an open question and is an active research area.
It is important to emphasize that behavioral managers can also be valuable to the firm. Specific corporate governance mechanisms can help to improve managerial decision making. For example, CEO stock ownership supports CEOs with de-biasing their beliefs, preferences, and expectations in order to prevent value-decreasing, or encourage value-increasing, actions e.
In extreme negative cases, the board of directors is able to identify CEOs with excessive behavioral biases and force them to depart e. A social principal-agent framework is developed to serve as a guide for future research in corporate finance. Since managers and shareholders take on a social position within and across markets, further research may increase the focus on novel identification strategies of how to explain certain corporate finance anomalies when both parties exhibit less than fully rational behaviors.
Another interesting topic is the idea to extend the social principal-agent framework involving behavioral intermediaries , for example, underwriters, analysts, and rating agencies, whose existence is justified by reducing information asymmetries between principals and agents.
Research in corporate finance shows that actions of intermediaries can either be traced back to or influenced by behavioral or social traits, states, and activities e. To sum it up, social agents, principals, and intermediaries have an impact on the destabilization of fundamental prices or on biasing of managerial decision making or both.
We thank the editor and, in particular, the anonymous reviewers for many constructive suggestions. We thank Csenge Kukolya for excellent research assistance. We apologize in advance to all the authors whose research related to behavioral and social corporate finance is not cited in this review owing to severe space constraints.
Of course, behavioral finance is in and by itself an outgrowth of behavioral economics, which started to develop with the seminal research by Simon and subsequently Kahneman and Thaler Arguments for why managers may be relatively more rational than shareholders include information advantages and no short-sales constraints.
For a review of papers showing that mispricing does occur in financial markets, see Shleifer It is important to note that specific personal characteristics must not always lead to non-standard beliefs or preferences but can also be correlated with standard factors, for example, gender differences in standard risk-taking preferences. In this section, we review studies which take a behavioral standpoint.
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Introduction Over the past two decades, there has been a rapidly growing interest in augmenting standard frameworks in corporate finance research with novel insights from cognitive psychology and, more recently, social psychology and sociology. Behavioral Principal-Agent Framework Our definition of behavioral corporate finance is straightforward in that it is a combination of a standard principal-agent framework and empirical evidence from psychology research on human behavior.
Open in new tab. Behavioral Principals In this section, papers with behavioral shareholders but with rational managers are reviewed Quadrant Q2, Figure 1. Investment Policies Real Investments. Financing Policies Equity Financing. Catering Catering refers to situations in which rational managers exploit variation in investor sentiment by exerting specific actions at their disposal to actively boost stock prices above fundamental values Action A3, Figure 2.
Distribution Policies Dividend Payment. Behavioral Agents In this section we review studies with behavioral managers who interact with shareholders in efficient capital markets Quadrant Q3, Figure 1. Other Policies Financial Reporting Policy. Behavioral States Several situational factors, that is, the context in which a human is located, affect behavior in the short term. Behavioral Activities Simon suggests a behavioral model of human decision making, arguing that information acquisition, time, and cognitive costs result in bounded rationality and thereby biases.
Financing Policies Debt Financing. Other Policies Risk Management. Behavioral Principals and Agents So far, only one of the actors in this behavioral principal-agent framework was assumed to be human. Social Traits Social traits, like behavioral traits, are relatively stable. Social States Social states comprise social processes between individuals.
Social Activities Social activities synthesize managerial assessments and decision-making actions, in the presence of other individuals or groups. Conclusion This article summarizes the currently existing academic research on behavioral and social corporate finance. Acknowledgments We thank the editor and, in particular, the anonymous reviewers for many constructive suggestions.
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Market timing and capital structure. Journal of Finance , 57 1 , 1— Barberis, N. A survey of behavioral finance. Bertrand, M. Managing with style: The effect of managers on firm policies. Quarterly Journal of Economics , 4 , — Dong, M. Does investor misvaluation drive the takeover market? Journal of Finance , 61 2 , — Guiso, L. The value of corporate culture. Journal of Financial Economics , 1 , 60— Hirshleifer, D. Behavioral finance. Annual Review of Financial Economics , 7 1 , — Social transmission bias and the cultural evolution of folk economic beliefs.
Behavioral and Brain Sciences , 41 , E Kahneman, D. Maps of bounded rationality: Psychology for behavioral economics. American Economic Review , 93 5 , — Malmendier, U. Behavioral CEOs: The role of managerial overconfidence. Journal of Economic Perspectives , 29 4 , 37— Polk, C. The stock market and corporate investment: A test of catering theory. Review of Financial Studies , 22 1 , — Roll, R.
The Hubris hypothesis of corporate takeovers. Journal of Business , 59 2 , — Shefrin, H. Behavioralizing finance. Foundations and Trends in Finance , 4 12 , 11— Shleifer, A. Inefficient markets: An introduction to behavioral finance. Oxford, U. Stock market driven acquisitions.
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Science , , — Zingales, L. Journal of Financial Economics , 1 , 1—4. References Adam, T. Managerial biases and debt contract design: The case of syndicated loans Working Paper. Adam, T. Managerial overconfidence and corporate risk management. Journal of Banking and Finance , 60 1 , — Adebambo, B. Investor overconfidence, firm valuation, and corporate decisions. Management Science , 64 11 , — Adhikari, B. Peer influence on payout policies.
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