BEHAVIORAL CORPORATE FINANCE – WITH SPECIAL REFERENCE TO GLOBALIZATION, LIBERALIZATION AND FINANCIAL SECTOR REFORMS

?

BEHAVIORAL CORPORATE FINANCE – WITH SPECIAL REFERENCE TO GLOBALIZATION, LIBERALIZATION AND FINANCIAL SECTOR REFORMS

??????????????????????????????????????????????????????????????????????????????????????????BY: Dr. Yogendra Nath Man *

?????????????????????????????????????????????????????????????????????????????????????????Mr. Kavindra Nath Mann **

?The field of finance, so far, has dealt with certain central paradigms derived from investor rationality, viz., portfolio allocation based on expected return and risk, risk-based asset pricing models, i.e., CAPM and other similar frameworks, the pricing of contingent claims, and the Miller-Modigliani theorem and its augmentation by the theory of agency. While these approaches revolutionized the study of finance and brought rigor into the field, many lacunae were left outstanding by the theories. For example, the traditional models had a limited role towards understanding trading volumes while focusing mostly on price data. The price data was used to compute returns, abnormal, as well as to understand the pricing phenomenon from the eyes of an efficient market researcher or to check the over or under-pricing of stocks. Though the benefits of diversification were emphasized by modern theories, individual investors often held only a few stocks in their portfolios. Finally, expected returns did not seem to vary in the cross-section only because of risk differentials across stocks. Based on the above observations, traditional finance appeared to play a limited role in understanding issues such as (i) why do individual investors trade, (ii) how do they perform, (iii) how do they choose their portfolios, and (iv) why do returns vary across stocks for reasons other than risk. Finance education in general can be more useful if it sheds specific light on active investing by addressing aspects such as (i) what mistakes to avoid while investing, and (ii) what strategies in financial markets are likely to work in terms of earning supernormal returns. Those are the main pedagogical goals of behavioral finance, which allows for explanations of financial phenomena based on non-rational behavior amongst investors. Behavioral finance — that is, finance from a broader social science perspective including psychology and sociology — is now one of the most researched areas in finance.

Behavioral finance is important at the individual as well as corporate levels. A lot of researches analysing corporate behavioral finance have been made in recent decades. However all are related to solutions of capital or debt financing problems, finding the best possible source of capital increase or the cheapest debt possibility.

The dominating role of the Efficient Market Hypothesis as a theoretical framework of investing ended with the development of the theory of Behavioral Finance. Since then these two approaches have been in constant conflict with one another. Investment rationality and efficient market ideas clearly contradict with an investor’s psychology and biased behavioral rules. Nevertheless, inefficient access to investment information and long term market anomalies provide evidence regarding the priority of Behavioral Finance.

??Literature Review

It's easy to get the impression from the literature review of on this topic that people are remarkably confused. Fair enough. Humans are, after all, humans. However, what gets far less attention are those studies that demonstrate that human fallibility isn't constant and seems to improve as we age and/or gain experience. Bateman et al. (2010) investigated the decision making of Australians in an experiment designed to replicate the portfolio selection process for those participating in the Australian equivalent of a defined contribution plan. When looking at the entire population of subjects, researchers found that between 14 percent and 37 percent of subjects made inconsistent choices when confronted with different methods of presenting data on the available portfolio choices. However, only 5 percent of subjects in the 55-n age group did so. Agarwal et al. (2009) looked at a far broader set of financial decisions faced by individuals and found that in 10 realms of personal finance, individuals make better decisions as they age, with the peak prowess at about 53 years. List (2003, 2011) has focused not on age, but experience. He's demonstrated how individuals are subject to the endowment effect when entering a market for the first time, but through repeated exposure to the market, substantially reduce the impact of the effect as they gain experience. The behavioral finance field grew up in a world where the prevailing academic assumption was that people, as a group, behave rationally. The assumption of rationality is a strong one and, over the decades, many studies have demonstrated both experimental and real-world evidence of violations of strictly rational behavior. Fair enough, people aren't fully rational, but it's dangerous to leap to the other extreme that people are utterly irrational. The Bateman study mentioned earlier is a relevant example. Depending on what model of rationality one uses, between 14 percent and 37 percent of people exhibited inconsistent risk preferences. However, between 63 percent and 86 percent got it right. Another example is from Barber and Odean (2004) who investigated how tax efficient individuals are when they invest. Not surprisingly, the results are a mixed bag. Investors tend to hold tax inefficient assets in tax-deferred accounts, and they practice some tax-loss harvesting. However, they aren't perfect and could do a better job. The bottom line is that we need to move away from a discussion where people are or aren't rational and toward the admittedly messier, but more realistic terrain where people reside somewhere on a continuum.

The term "corporate finance" describes the interaction between company managers and investors and its impact on company value, i.e. the theory of corporate finance tries to explain financial contracts and investment behavior arising from the interaction between managers and investors (according to this theory, managers should make unbiased forecasts of future events and use them in making decisions that best suit their own interests) (Baker & Wurgler, 2011). According to modern corporate finance business executives and investors act rationally when taking financial decisions. If the assumption of rational behavior is correct, managers can expect that capital markets are efficient, implying that stocks and bonds are priced correctly at every given moment (stock prices correctly reflect the public information about their fundamental value). According to this theory the behavior of managers in decision-making will be based on the principle of self-interest (Shah, 2013). Based on the fact that the primary role of the capital market is redistribution of property, which is effective when price helps a fair redistribution of resources, Fama (1970) pointed out that the market was called efficient when prices fully revealed available information. In terms of the impact of the efficient market theory on corporate financial decisions it should be added that based on this theory it has been customary to assume that information about the securities and the market as a whole spreads very quickly and is reflected in prices of the securities without delay (Malkiel, 2003). Thus, since the end of the twentieth century finished the global domination of the efficient market hypothesis; a significant part of modern economists support the idea that the stock price is at least partially predictable, emphasizing the psychological and behavioral factors of the stock price and arguing that stock prices can be at least partially predictable based on their trends in the past and fundamental analysis (Malkiel, 2003).

Recent literature research has shown that a rational assumption of the behavior of corporate executives and investors cannot be done in reality (Shah, 2013). Empirical studies have shown that investors taking financial decisions pay attention to peripheral information or “noise” (Black, 1986). In addition it was observed that deviations from rational behavior are not random but systematic and depend on the approach to risk assessment and uncertainty of future problems of the impact of decision-making (Kahneman & Riepe, 1998). When the traditional approach to corporate finance is based on the company's value-based management and the three conditions - rational behavior, the fixed asset pricing model, and efficient markets, the proponents of behavioral corporate finance argue that psychological factors influence the traditional paradigm of the three components (Shefrin, 2001). It is believed that psychological phenomena do not allow decision-makers to act completely rationally, and stock market prices do not reflect the fundamental value. In terms of investor irrationality it can be said that many scientific works on cognitive psychology have proved that investors, who are too confident in their knowledge and abilities, make systematic errors when thinking and making decisions, they give too much weight to their recent experience, etc.; distortions may also cause investors’ preferences (Shah, 2013).

As the sub-discipline of financial behaviour, corporate financial behavior integrates economic and psychological studies investigating financial decision-making by companies and deviations under conditions of uncertainty and criticizes the earlier discussed theory of corporate finance and compensatory strategies. When analyzing scientific literature on the subject of behavioural corporate finance (Baker & Wurgler, 2011; Shah, 2013, et al.), we can distinguish two main approaches:

? The first approach is based on the impacts of irrational investor behaviour on rational corporate executives;

? The second approach refers to the examination how irrational executive decisions impact the value of a

company.

Behavioral Finance Traits There are many concepts which characterize the behavioural finance. Such traits which are observed in the behavior of investors are enumerated as under:

Loss Aversion: Investors do not like losses and often engage in mental gymnastics to reduce their psychological impact. Loss aversion reflects the tendency for people to weigh losses significantly more heavily than gains. Loss aversion can be observed in our tendency, when faced with a choice between a sure loss and an uncertain gamble, to gamble unless the odds are strongly against us. Their tendency to sell a winning stock rather than a losing stock is called the disposition effect in some of the behavioral finance literature. Shefrin and Statman(1985) coined the term disposition effect, as shorthand for the predisposition toward get-even.

Fear Of Regret: Investors do not like to make mistakes. People tend to feel sorrow and grief after having made an error in judgment. This trait makes people slow to act (or unable to decide). One theory is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment.

Myopic Loss Aversion: Investors have a tendency to assign too much importance to routine daily fluctuations in the market. (i.e., be shortsighted). Abandoning a long-term investment program because of normal market behavior is sub optimal behavior. Checking on investment portfolio frequently can lead to loss of discipline in adherence to a well thought out long term investment plan and lead to buy high and sell low trading.

Herding: Herding refers to the lemming-like (a propensity to follow blindly after a leader) behavior of investors and analysts looking around, seeing what each other is doing, and heading in that direction. Herding reflects the feeling of safety and well-being by behaving in harmony with the group. As many recent financial disasters show, there may not have been safety in numbers, but there probably was some comfort in them. As someone probably said: “I lost money but at least I had company”.

Anchoring: Reflects the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. When anchoring, people base decisions or estimates on events or values that are known to them, even though these facts may have no bearing on the actual event or values.In the context of investing, investors will tend to hang on to losing investments by waiting for the investment to "break even" with the price at which it was purchased. Thus, these investors anchor the value of their investment to the value it once had, even though it has no relevance to its current valuation.

Illusion of Control: Refers to people’s belief that they have influence over the outcome of uncontrollable events.

Prospect Theory: Risk averse investors get increasing utility from higher levels of wealth, but at a decreasing rate. Kahneman and Tversky (1979) showed that while risk aversion may accurately describe investor behavior with gains, investors often show risk seeking behavior when they face a loss.“I can’t quit now, I am too far down”. This has the implication that money managers may take bigger chances when things have not gone their way in an attempt to recover the losses.

Mental Accounting: Mental accounting refers to our tendency to “put things in boxes” and track them individually. For example, investors tend to differentiate between dividend and capital (gain), and between realized and unrealized gains. To give an example, the practice of buying dividend-paying stocks so that one can avoid "dipping into capital" - selling stock - to pay for life's necessities.

Asset Segregation: Asset segregation refers to our tendency to look at investment decisions individually rather than as part of a group. The portfolio may be up handsomely for the reporting period, but the investor will still be concerned about the individual holdings that did not perform well.

Hindsight Bias: Hindsight bias refers to our tendency to remember positive outcomes and repress negative outcomes. Investors remember when their pet trading strategy turned up roses, but do not dwell on the numerous times the strategy failed.

Overconfidence: Overconfidence refers to our tendency to believe that certain things are more likely than they really are. For example, most investors think they are above-average stock pickers. Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market, however, most fail to do so.

Framing: The concept of framing involves attempts to overlay a situation with an implied sense of gain or loss. It is easier to pay Rs.3,400/- for something that you expected to cost Rs.3,300/- than it is to pay Rs.100/- for something you expected to be free. Though the economic impact is Rs.100/- for both the cases. According to Daniel Kahneman (1979), “A loss seems less painful when it is an increment to a larger loss than when it is considered alone.” –

Availability Heuristic: The availability heuristic is the contention that things that are easier to remember are thought to be more common.

Illusion of Truth: People tend to believe things that are easier to understand more readily than things that are more complicated. Most investors prefer a low PE ratio, since they prefer to buy low-priced stocks with high earnings, and this idea is easy to understand. Some people believe that stock splits and cash dividends are wealth-enhancing events, even when we know that these corporate events do not affect shareholder wealth at all.

Biased Expectations: Our prior experience causes us to anticipate certain relationships or characteristics that may not apply outside our frame of reference. For example, a stock in US may sell at a price of $2.15 and the investor in US may infer that it is a risky, young company, that pays no dividends. However, comparing with India, a lot of established and large companies trade at an equivalent dollar price of $2.15?or so.

Reference Dependence: “That stock was Rs.800 last year, now it's trading at Rs.200 - so it's got to be cheap." This is known as reference dependence, and it's the tendency to focus on some point of reference. Investment decisions seem to be affected by an investor's reference point. If a certain stock was once trading for Rs.200/-, then dropped to Rs.50/- and finally recovered to Rs.100/-, the investor's propensity to increase holdings of this stock will depend on whether the previous purchase was made at Rs.200/- or Rs.50/-.

Role of Mistaken Statistics: There are some other tendencies that may have a behavioral influence on asset values. These involve “innumeracy” or a misunderstanding of the likeliness of an event or series of events. Some of these are:

(a) Extrapolation: We have a tendency to assume that the past will repeat itself and to give too much weight to recent experience. Some investors believe that because a stock has risen in the past recently it will continue doing so in the future. A belief that recent occurrences influence the next outcome in a sequence of independent events is known as the gambler’s fallacy.

(b) Percentages Vs Numbers: Many people process numbers and percentages differently. For example, consider the following two statements about rise in incident of a disease:

Version A: The incidence of a disease rose 30%

Version B: The incidence of a disease rose from 10 in a million to 13 in a million. We would likely find that to many people, 3 more cases is not a cause for concern, although a 30% increase is.

(c) Sample Size: There are many instances where people draw incorrect inferences from statistical data. Small sample problem: Thinking that a few observations can lead towards a meaningful inference, when it may not mean anything. The mistake is compounded when the sample is biased. Even in large samples, statistical significance does not mean that it is important or interesting.

(d) Apparent Order: A single occurrence of an unlikely event becomes much more likely as the sample size increases. However, many people will find a run of six consecutive numbers in a daily state lottery extremely unlikely. There is nothing special about outcomes that have an “apparent order”.

(e) Regression to the Mean: The regression to the mean concept states that given a series of random, independent data observations, an unusual occurrence tends to be followed by a more ordinary event. Investments Interpretation: Good performance tends to be followed by lesser results. Hence, chasing last year’s mutual fund or stock with the best performance is likely to be a losing strategy, although many investors do precisely this.

?Conclusions

The research of studies on behavioral corporate finance demonstrates that they are associated to capital or debt financing problems. Enquiries reveal that executives making solutions in financial / investment decision are influenced by their individual preferences, mostly when management of the corporation is weak. Moreover, individual actions sometimes describe financial activities of corporations, in which the decision makers are employed.

The main motivation of companies’ investments is to generate income and to accumulate funds for implementation of projects directly related to company activities. In addition, the experts give prominence to tax impact. Companies are relatively conservative when making investment decisions. The experts confirm that short-term fluctuations of investment portfolios would not change corporate decisions, and companies tend to minimize the risk as the majority ?hold cash or deposits. In addition, the experts point out that most companies choose investment periods of up to 1 year, sometimes extended up to 5 years. When determining companies’ investment behavior the majority of the experts state that companies would choose the lower risk-lower returns portfolio.

Corporate need a lot of improvement in some of those aspects referring to management and corporate governance: sensible incentives that mix the personal interest with corporate risk and reward, control & communication systems, risk management systems, accounting standards and procedures and human resources. As investors, we also need to take in consideration aspects like dividends, earnings announcements and the evolution of closed-end funds industry in order to understand better the investors and the market’s sentiment, the price momentum and price reversal so we may increase further our wealth.

?REFERENCES

1.?????Adler , David E, A Behavioral Theory of Corporate Finance, Spring-2004, Issue 34, Strategy and Business magazine.

2.?????Agarwal, S., Driscoll, J.C., Gabaix, X., &Laibson, D. (2009). The Age of Reason: Financial Decisions Over the Lifecycle with Implications for Regulation.

3. Chandra, Uday, Wasley, Charles E. and Waymire, Gregory B., Income Conservatism in the U.S. Technology Sector (January 5, 2004). Simon School Working Paper No. FR 04-01.

4.?????Dr. Kapil Arora, Behavioral Finance – An Insight intothe Investor’s Psyche, IOSR Journal of Economics & Finance, pp-41-45.

5.?????Fairchild, R. (2005b), “The effect of managerial overconfidence, asymmetric information, and moral hazard on capital structure decisions.” ICFAI Journal of Behavioral Finance, vol II, no 4, 46- 68.

6.?????Hirshleifer, D. & Teoh, S.H. (2003). Herd behaviour and cascading in capital markets: A review and synthesis. European Financial Management, 9 (1), 25–66.

7.?????Montier, James; Behavioral Finance: Insights into Irrational Minds and Markets: 2007, John Wiley & Sons.

8. Myers, S.C. and Majluf, N.S. (1984), “Corporate financing and investment decisions when firms have information that investors do not have.” Journal of Financial Economics 13, 187-221.

9. O. Lamont and R. Thaler, “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,” Working Paper, University of Chicago, 2000.

10. P. Schultz and M. Zirman, “Do the Individuals Closest to Internet Firms Believe They are Overvalued?,” Journal of Financial Economics, Vol. 59 (2001).

11. Pinal Shah: Behavioral Corporate finance: A New Paradigm shift to understand corporate decisions?Global Research Analysis International, Volume-2, Issue-1, January, 2013.

12. Rassoul Yazdipour, Behavioral Finance and Entrepreneurial Finance, The Journal of Entrepreneurial Finance, Volume 11, Issue 1, Spring 2006.

13. Richard Fairchild, Behavioural Corporate Finance: Existing Research and Future Directions, Research Paper by School of Management, University of Bath, UK., September 3rd 2007.

14. Sridhar R. Arcot and Valentina G. Bruno, ?In Letter but not in Spirit: An Analysis of Corporate Governance in the UK” London School of Economics, 2006

????????????????????????????**************************************

*Dr. Yogendra Nath Mann is retired Assistant General manager – State Bank of India and former Associate Professor(Banking & Finance) – Dr. Gaur Hari Singhania Institute of Management and Research, Kanpur.

** Mr. Kavindra?Nath?Mann is retired Deputy General Manager and Principal, Staff Training College, Bank of India, Chennai.??????