Behavioural Finance
1 Introduction
When we are asked to advise on a financial decision in the exam - whether it concerns, for example, advising which shares an investor should buy, or whether it concerns, for example, advising how much the financial manager should offer for the acquisition of another company - we assume that the investor or financial manager is acting rationally.
For example, if we are appraising a project we calculate the Net Present Value and if the NPV is positive then we advise that the project should be accepted - this is what rationally the decision should be.
In real life, investors and financial managers do not always make rational decisions and behavioural finance seeks to explain why this is the case.
It does so by examining the assumptions behind rational decision making and why those assumptions may not hold in real life.
2 Assumptions of rational decision making
The following assumptions underlie rational financial decision making:
Financial decision makers seek to maximise their utility. By this we mean that investors wish to maximise the value of their portfolio of shares, and that financial managers wish to maximise the value of their company.
Financial decision makers base their decisions on analysis of all relevant information.
The analysis of financial information that they undertake is rational, objective, and risk-neutral.
We will examine each of these assumptions, firstly for investors, and secondly for financial managers.
3 Investors
3.1 Maximisation of utility.
As already stated, we assume that investors aim to maximise their long-term wealth. However they may decide not to invest in what may be financially attractive companies because they regard them to be unethical e.g. cigarette manufacturers. Also, it is common for investors to hold on to investments that have lost value (and are expected to continue to lose value) because they do not wish to admit to themselves that they made a mistake in not selling them sooner.
3.2 Analysis of relevant information
The most relevant information in deciding where to invest is information as to the future prospects of the company in question. However, other, irrelevant, factors may influence the decision. For example, buying shares in a company because many others are buying the shares (the herd instinct) or selling shares because the price has been rising for some time, and therefore feeling that the price cannot continue to rise.
3.3 Rational, objective and risk-neutral analysis
However much relevant information is available, we assume that investors use all of this information rationally and objectively, but this is not always the case. There is a tendency to attach more importance to the elements of information available that confirm beliefs that they already have, and less importance to other information.
4 Financial managers
4.1 Maximisation of utility
The objective of financial managers is to maximise shareholders wealth. However there have been many examples of situations where decisions have not been rational. For example, they may have made a rational offer for the acquisition of another company, but have ended up paying more than is rational because other companies have made bids and they have ended up in competition with them - they end up paying more than is rational rather than lose out to another company.
4.2 Analysis of relevant information
One big unknown when considering the amount to offer for the acquisition of another company is the extent to which the management of the acquiring company will be able to improve the results of the target company.The managers of the acquiring company may have an unrealistic opinion as to their skills in this respect and as a result may end up paying too much for the target company.
4.3 Rational, objective and risk-neutral analysis
It is difficult for all decision makers to be completely objective when making decisions and to therefore give equal importance to all relevant information. Just as previously explained in respect of investors, financial managers are likely to attach more importance to those elements of information that confirm their basic feelings, and less importance to other elements of information.