INDIVIDUAL ASSIGNMENT:

Essay 5:
Discuss the nature of behavioural corporate finance, the differences
with traditional financial management theories and/or some of the
specific behavioural theories. Use relevant real world examples
wherever possible.

This paper focuses on the traditional financial management theories as well as some of the
corporate behavioural finance theories. The ways in which they differ are also discussed and
in order to better understand this framework, examples will be used where appropriate.
Behavioural Corporate Finance
Behavioural finance has many implications when practicing corporate finance (Shefrin,
2001). Gupta, Preetibedi and Mlakra (2014) define behavioural finance as the study of
investor market behaviour that drives from psychological principles of decision making, to
explain why people buy or sell the stocks. Behavioural finance is therefore based on the
alternative conception that some, if not all investors are prone to behavioural biases (Byrne
and Brooks, 2008). This hence indicates that the financial decisions they make can be thought
to be less rational, whereby evidence of such biases has been extracted from cognitive
psychology literature and applied to a financial context (Byrne and Brooks, 2008).
There are however, quite a few examples of behavioural biases, the first being regret
aversion. This is whereby, individuals make a decision which avoids them from facing the
emotional consequences (such as pain) in the event of an adverse outcome (Byrne and
Brooks, 2008). Mental accounting is another bias where Byrne and Brooks (2008) state that
individuals allocate wealth to separate mental compartments and ignore fungibility and
correlation effects. Prospect theory can also be thought of a descriptive theory of decision
making in risky situations (Byrne and Brooks, 2008).
Information processing on the other hand, is when errors are made whilst processing
information which can lead investors to misjudge the true probabilities of associated rates of
return or possible events (Bodie, Kane and Marcus, 2014). Overconfidence and over
optimism is a type of information processing whereby the individual investor overestimates
the ability and accuracy of the information they possess (Byrne and Brooks, 2008). For
example, using Sony Corporation as a case study (Shefrin, 2001). Ibuka was their manager
who insisted on developing a commercial prototype even though there was a negative unit
gross margin (Shefrin, 2001). The behavioural elements are therefore overconfidence and loss
aversion. Committing Sony mass production to produce the product before a cost-effective
mass production process was even developed, showed that overconfidence prevailed (Shefrin,
2001). Loss aversion on the other hand prevailed when Ibuka continued to invest in the
project and would not accept a sure loss even though losses began to mount (Shefrin, 2001).

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Nevertheless, conservatism, representativeness and availability bias can also be added to the
list. Conservatism can be explained through investors and forecasters sticking to their
previous beliefs even though new information is made available; nevertheless,
representativeness is whereby superficial characteristics are used by investors, rather than
them assessing situations through underlying probabilities; and lastly, availability bias is
when the probabilities of recently observed events are overstated by investors because their
memory is fresh (Byrne and Brooks, 2008).
Traditional Finance Theory
Traditional finance makes use of models whereby economic agents are assumed to be rational
(Byrne and Brooks, 2008). When the term rational is used, it implies that markets are
efficient, unbiased processors of information and that their decisions are consistent with
utility maximization (Byrne and Brooks, 2008), which is known as the classical decision
theory (Baker and Filbeck, 2013).
Based on the restricted assumptions, there are three main concepts that illustrate the practice
of value based management, that contribute to the traditional approach to corporate finance.
The first being rational behaviour, which implies that psychological phenomena restricts
decision makers from acting in a rational manner.
Adding onto the theories is that of Markowitz which deals with portfolio consumption. The
theory of portfolio choice shows that the risk of an asset cannot be evaluated in isolation but
it should be based on its contribution towards the risk portfolio (Beekman Wealth Advisory,
2016). Portfolio managers and financial advisors had conducted very little systematic
evaluation to diversify portfolios but instead relied on hunches (Baker and Filbeck, 2013).
Therefore, early theorists then realized that investors should only be compensated for
systematic risk and not risks they could avoid through diversification. The resulting effect
was the Capital Asset Pricing Model (CAPM) (Baker and Filbeck, 2013).
Thirdly, CAPM states how individual assets theoretically behave and that investors only commit money to investments that have an expected return sufficient to compensate for the risk
they are assuming (Beekman Wealth Advisory, 2016). Baker and Filbeck (2013) state that the
CAPM is a model that is also used to assist investors when evaluating how stock and other
assets are priced.

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Lastly, Shefrin (2001) states that efficient markets describe how the community of investors
also known as the market, theoretically behave (Beekman Wealth Advisory, 2016), and
follow that market prices are regularly at odds with fundamental values. The Miller and
Modigliani theory showed that in practice, two companies that have the same degree of risk
but differing WACC would not stay in disequilibrium for long (Lumby and Jones, 2003). This
is where arbitrage comes into play, whereby advantage is taken of the price differentials
between two or more markets because the arbitragers would enter the market and equal the
two companies out (Lumby and Jones, 2003).
Differences between behavioural corporate theories and traditional finance theories
Traditional finance differs from corporate behavioural finance in the sense that, the latter
takes into consideration the effect of an individual agents qualities (particularly
psychological characteristics) on decisions (Labao, 2016). For example, when making
financial decisions, corporate behavioural finance aims to determine whether managers suffer
from overconfidence and whether that has a particular impact on their choices (Labao, 2016).
Traditional finance models assume that an individuals choices are consistent, in the sense
that they will make the same decisions regardless of how the problem is presented, however,
with behavioural finance, the framing effect states that the individuals choices are in fact not
consistent which then enables one to predict their decisions (Labao, 2016). Adding onto the
differences, is that people in traditional finance theory are said to be rational whereas in
behavioural finance, people may not always be rational and can be confused by aspects such
as framing, regret and cognitive errors (Statman, 1995). Lastly, behavioural finance argues
that the downfall of arbitrage is that arbitragers may not be able to profit from market
dislocations caused by less rational investors, as well as psychology which catalogues the
different deviations that may be seen in financial markets (Herschberg, 2012).
In conclusion, traditional finance is a well based Miller and Modiglianis principle of
arbitrage, the portfolio construction principles of Markowitz and the CAPM (Statman, 1995).
This however, does not do well as a descriptive theory of finance as investors fail to overlook
arbitrage opportunities, use the portfolio construction principles when constructing their
portfolios, and lastly, fail to drive stock returns to appropriate levels with the CAPM
(Statman, 1995). Therefore, behavioural finance is better built to take into consideration
human behaviour which allows them to be able to better deal with issues that traditional
finance theories cannot explain (Statman, 1995).
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