Motorola launches Iridium.

In 1987, a team of engineers presented the case for a space-based cellular-phone system to three top Motorola executives, including then-chairman Robert Galvin. "The project was going to involve putting at least 50 satellites in space in order to do something that was extremely sophisticated and had never been done before," recalls Hersh Shefrin of Santa Clara University's Leavey School of Business. "It was going to require an outlay of several billion dollars over at least a decade." At the end of the two-hour presentation, what was the action item? "'Go for it,'" answers Shefrin. "No discounted cash flow, no net present value, no internal rate of return, no payback period—nothing." By the time Iridium finally debuted, in November 1998, Motorola had shelled out some $5 billion for the project. The next year, Iridium declared bankruptcy and was sold off to private investors.

America Online and Time Warner merge. There are two behavioral aspects to the catastrophic $163 billion uber-deal that was announced in January 2000, says Shefrin. One is inefficient markets. "Brealey and Myers [authors of the best-selling textbook on corporate finance] tell managers explicitly: Trust market prices," he says. "Well, if [AOL CEO] Steve Case trusted market prices, he would never have bought Time Warner with AOL stock. But he thought AOL was incredibly overvalued, and he was looking for a good deal."

The second aspect is overconfidence. Case and Time Warner CEO Gerald Levin had discussed a possible deal for months, but only a handful of Levin's colleagues knew about it. A merger of equals was the goal, but in December 1999, AOL stood firm: it wanted a majority stake in the new company. "What's Levin's action item?" asks Shefrin. "Does he get together with his board members and closest advisers and discuss, should we do it? No. He goes to his weekend retreat, he thinks about it—and he makes the decision." Levin settled for a 45 percent stake, and the deal was done. When it was announced, those who were shocked by the news included Time Warner's CFO, general counsel, and board. The company's stock has since dropped 70 percent, and some $200 billion in shareholder value has evaporated.

Troubling Thoughts

The literature on behavioral finance contains many examples of how cognitive biases lead people to make flawed decisions. Hersh Shefrin, professor of finance at Santa Clara University's Leavey School of Business, says that corporate managers should be particularly wary of the following.

Overconfidence and optimism. CEOs who overrate their abilities are prone to making M&A mistakes. Confidence is a sine qua non of CEOs; overconfidence is their Achilles' heel.

Loss aversion and aversion to a sure loss. Studies show that people are far more sensitive to a loss than to a gain of equal magnitude. Also, they have a tendency to gamble in order to avoid a sure loss. In corporate practice, this means that despite textbook advice to ignore sunk costs, managers will throw good money after bad in the attempt to salvage a failing investment.

Confirmation bias. Managers tend to overweight evidence that supports their views and underweight evidence to the contrary.

Frame dependence. How something is framed, or packaged, will affect how decisions are made. One example is the treatment of stock options in financial statements. "The traditional frame-independent, nonbehavioral perspective says it shouldn't matter whether you drag stock options to the income statement or just leave them in the footnotes," says Shefrin. "The underlying fundamentals are the same." Here, frame dependence goes hand-in-hand with inefficient markets, he adds. "If we had frame independence on the part of investors, and if markets were efficient, expensing stock options would be a nonissue. But because markets are inefficient, and investors respond differently depending on how the information is framed, it matters whether a particular treatment of stock options is made."

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