Watch How You Think

With the U.S. economy roaring back to life in the third quarter of 2003, the revival of what economist John Maynard Keynes called the "animal spirits" of investors may be at hand. And that, to some observers, portends an uptick in merger-and-acquisition activity (see "The Start of Something Big?").

Inevitably, however, many companies will make deals that they will come to regret. Study after study shows that most mergers and acquisitions destroy value, at least in the short term. Why do so many acquisitions fail? Experts typically cite a number of reasons—synergies and cost savings that don't materialize, intractable integration problems, insuperable cultural differences, and so on. Acquisitions, they conclude, are inherently risky undertakings.

To those in the field of behavioral finance, however, the fundamental problem is psychological. CEOs who engage in M&A activity, they say, tend to be overconfident. And overconfident CEOs are prone to pursue risky deals, or pay too much (the "winner's curse"), because they overestimate the returns they can produce from an acquisition.

"Every CEO who goes into [an acquisition] thinks he is different—that he will be able to pull it off," says Hersh Shefrin, professor of finance at Santa Clara University's Leavey School of Business and a leading advocate of behavioral finance. As a group, says Shefrin, CEOs are afflicted with what he calls "the Lake Wobegon syndrome," named after Garrison Keillor's mythical community where "all of the children are above average."

Whether would-be dealmakers are now inclined to pay greater attention to psychological considerations is difficult to say. But the lessons provided by the collapse of the stock-market bubble in 2000 serve to advance the cause of behavioral finance, an approach that applies psychology and sociology to finance. Researchers in this growing field can cite numerous value-destroying deals that, they assert, were the result of CEO overconfidence (see "From the Annals of Hubris," at the end of this article).

Most evidence for what is sometimes called the "hubris hypothesis" is circumstantial. "You'd love to interview CEOs before [deals are made]," says Terrance Odean, associate professor at the Haas School of Business at the University of California, Berkeley. But the circumstantial case is strong, he adds.

"If you see that acquisitions lose money over and over and over again—at different times, and in different industries—then you have to start saying, 'It looks like a bit of a pattern,'" says Odean. "And it's not to say that every single one of them was a mistake, but on average, there seems to be a bias toward buying when you'd be better off not buying."

To behaviorists, the explanations for this bias boil down to two: "either people are making honest behavioral decision errors, or they're cynical," says Odean. "You can explain some of these deals with agency theory—maybe it was bad for the company, but it was good for the guy who made the decision. And sometimes that's true. But I prefer to think that rather than a lot of corporate leaders are selfish and cynical, at least much of the time a wrong decision was made because of a combination of factors like hubris."

Judging Judgment
According to behavioral-finance theorists, overconfidence is one of a host of well-documented cognitive biases—systematic errors in the way people process information (see "Troubling Thoughts," at the end of this article). Shefrin likes to warm his students to the subject of overconfidence by asking them to rate themselves as drivers. "Typically, 40 percent say they're above average, 50 percent average, and 10 percent below average," he says. "Few people are willing to admit to being below average."

Two other pioneers, Richard H. Thaler and Robert J. Shiller, advanced the integration of economics and psychology by solving puzzles of economic behavior (Thaler)—why people adjust so poorly to a decline in wages, for example, or are reluctant to take a high deductible in insurance—and revealing the excessive volatility of the stock market (Shiller). Indeed, although much research has been conducted in the lab, devoted to experiments and problems that illuminate the effects of cognitive biases, behavioral finance relies heavily on real-world data. Shiller and others, for example, have compared historical dividend values and stock prices; Odean and others have found evidence of irrational behavior in the actual account records of thousands of individual investors.

The emphasis of behavioral finance on studying how investors and markets actually behave—as opposed to positing how they should behave—has created serious problems for two core assumptions of prevailing economic dogma. One assumption is that markets are efficient, with prices fully reflecting available information. The other is that investors will make rational, well-informed decisions under uncertainty. Behavioral finance argues instead that markets are inefficient, prices are more or less irrational, and people—investors, CEOs, even CFOs—are prone to systematic errors of judgment.

Optimistic to a Fault
The past two years have seen an explosion of interest in behavioral corporate finance. Shefrin, for example, is writing what he says will be the first textbook of behavioral corporate finance, to be published in 2005 by McGraw-Hill. When he proposed the book two years ago, he recalls, "the question I got from every publisher was, is there such a thing as behavioral corporate finance?"

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