Behavioral Finance | Finance

Referencing Styles : Harvard

Behavioral finance holds important implications for the practice of corporate finance. The traditional approach to corporate finance, embodied by the practice of value- based management which is based on three concepts: (1) rational behavior, (2) the capital asset pricing model (CAPM) and (3) efficient markets. Proponents of behavioral finance argue that psychological forces interfere with all three components of the traditional paradigm. They maintain that psychological phenomena prevent decision makers from acting in a rational manner, which security risk premiums are not fully determined by security betas, and that market prices are regularly at odds with fundamental values.

There are two key behavioral obstacles to the process of value maximization, one internal to the firm and other external. The first obstacle to value creation is behavioral costs. Behavioral costs are tend to undermine value creation. They are the costs or alternatively, the loss in value associated with errors that managers make because of cognitive imperfections and emotional influences. The second obstacle stems from behavioral errors by analysts and investors. These errors can create a wedge between fundamental values and market prices. Proponents of behavioral finance argue that risk is not priced in accordance with the CAPM and the market prices often deviate from fundamental values. There is ample evidence that market prices and fundamental values often part company.

These issues can be connected to corporate decision making. Practitioners who follow a value-based management approach often assume that fundamental values and market values coincide. However, when these values differ, manager who seeks to maximize fundamental value may find that their actions lower the market value of their firm. Managers may find themselves unsure of how to factor the errors of analysts and investors into their own decision making.

a.    Critically analyze some of the more prominent behavioral characteristics of decision making.
b.    Describe how these characteristics create internal and external obstacles to value maximization in the context of real-world examples.

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