Irrationality of managers’ behavior in corporate financial decision making

Purpose of the study: The subject of consideration is the behavioral aspects of corporate finance. The consideration is devoted to the basic inclinations of psychological nature characteristic of managers. The main purpose of the article is to characterize the irrational behavior of managers in the process of financial decision-making in the enterprise. Methodology: The paper was prepared with the use the critical literature review method mainly in the field of behavioral corporate finance. Main findings: The discussion shows that behavioral corporate finance focuses mainly on cognitive and motivational-emotional processes in managers, which may occur in various decision areas within which managers make choices. There are three groups of psychological phenomena and inclinations that are characteristic of managers who manage business entities, namely predispositions to systematic inference errors, heuristics, and the presentation effect. Application of the study: The presented article refers to the irrational behavior of managers in the process of making financial decisions in the company. It implies reflections in such scientific fields as, among others, economics and finance, management and psychology. The use of the tools of psychology allows analyzing the problems of financial decision-making of managers in the enterprise, noticing in them some deviations from rationality that can affect the efficiency of the enterprise. The content of the article can be useful for managers making financial decisions in an enterprise. Originality/Novelty of the study: Behavioral finance is a young discipline of finance, the scientific output of which in Poland is still small. Behavioral aspects are just beginning to gain importance in the decision-making process, especially the financial one. The tendencies of managers to irrationality in the decision-making process presented in this article allow us to better understand the errors, psychological factors that may cause wrong decisions, which in turn may translate into poorer financial condition of the whole enterprise. The article can inspire further research and inquiry in the field of behavioral finance and contribute to other interesting scientific studies.

Behavioral Corporate Finance: The Life Cycle of a CEO Career

One of the fastest-growing areas of finance research is the study of managerial biases and their implications for firm outcomes. Since the mid-2000s, this strand of behavioral corporate finance has provided theoretical and empirical evidence on the influence of biases in the corporate realm, such as overconfidence, experience effects, and the sunk-cost fallacy. The field has been a leading force in dismantling the argument that traditional economic mechanisms—selection, learning, and market discipline—would suffice to uphold the rational-manager paradigm. Instead, the evidence reveals that behavioral forces exert a significant influence at every stage of a chief executive officer’s (CEO’s) career. First, at the appointment stage, selection does not impede the promotion of behavioral managers. Instead, competitive environments oftentimes promote their advancement, even under value-maximizing selection mechanisms. Second, while at the helm of the company, learning opportunities are limited, since many managerial decisions occur at low frequency, and their causal effects are clouded by self-attribution bias and difficult to disentangle from those of concurrent events. Third, at the dismissal stage, market discipline does not ensure the firing of biased decision-makers as board members themselves are subject to biases in their evaluation of CEOs. By documenting how biases affect even the most educated and influential decision-makers, such as CEOs, the field has generated important insights into the hard-wiring of biases. Biases do not simply stem from a lack of education, nor are they restricted to low-ability agents. Instead, biases are significant elements of human decision-making at the highest levels of organizations. An important question for future research is how to limit, in each CEO career phase, the adverse effects of managerial biases. Potential approaches include refining selection mechanisms, designing and implementing corporate repairs, and reshaping corporate governance to account not only for incentive misalignments, but also for biased decision-making.

Behavioral and Social Corporate Finance

Corporate finance is about understanding the determinants and consequences of the investment and financing policies of corporations. In a standard neoclassical profit maximization framework, rational agents, that is, managers, make corporate finance decisions on behalf of rational principals, that is, shareholders. Over the past two decades, there has been a rapidly growing interest in augmenting standard finance frameworks with novel insights from cognitive psychology, and more recently, social psychology and sociology. This emerging subfield in finance research has been dubbed behavioral corporate finance, which differentiates between rational and behavioral agents and principals. The presence of behavioral shareholders, that is, principals, may lead to market timing and catering behavior by rational managers. 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. Rational managers will also incite mispricing, for example, cater to non-standard preferences of shareholders through earnings management or by transitioning their firms into an in-fashion category to boost the stock’s price. The interaction of behavioral managers, that is, agents, with rational shareholders can also lead to distortions in corporate decision making. For example, managers may perceive fundamental values differently and systematically diverge from optimal decisions. Several personal traits, for example, overconfidence or narcissism, and environmental factors, for example, fatal natural disasters, shape behavioral managers’ preferences and beliefs, short or long term. These factors may bias the value perception by managers and thus lead to inferior decision making. An extension of behavioral corporate finance is social corporate finance, where agents and principals do not make decisions in a vacuum but rather are embedded in a dynamic social environment. Since managers and shareholders take a social position within and across markets, social psychology and sociology can be useful to understand how social traits, states, and activities shape corporate decision making if an individual’s psychology is not directly observable.