Once a fringe subject, behavioral finance is now taught in business schools across the land. The notion that psychological factors can distort financial decision-making is widely accepted, although the effects of such distortions on markets continue to be debated. Most research in the field has focused on investor behavior and asset pricing.

Increasingly, experts are applying behavioral principles to the realm of corporate finance. CFOs are susceptible to psychological biases too, and as a result their judgments and decisions can be less than optimal. Finance executives commonly miss opportunities to maximize value by stumbling into “behavioral traps,” says Hersh Shefrin, the Mario L. Belotti Professor of Finance at Santa Clara University’s Leavey School of Business.

Shefrin, a pioneer in the field, has written a new textbook that suggests how to avoid such traps. The first of its kind, Behavioral Corporate Finance: Decisions That Create Value (McGraw-Hill Irwin, $65) is intended for business-school use, replete with chapter summaries and questions for study. But CFOs who don’t remember the last time they sat in a classroom may also find this slim (200 pages), softcover volume rewarding — particularly if it helps correct expensive habits of thought. (Disclosure: the reporter, who has interviewed Shefrin before, is one of many people named in the acknowledgments.)

The book aims to supplement, not replace, standard texts on corporate finance, says Shefrin. Once students have learned traditional techniques, they can read about the well-established psychological phenomena that can skew the implementation of those techniques. All major areas of corporate finance are covered: capital budgeting, capital structure, valuation, corporate governance, mergers and acquisitions, and more.

Mental Shortcuts

The psychological phenomena, expounded in the opening chapter, come in three kinds: biases, heuristics, and framing effects. Biases, defined as predispositions toward error, are legion; four that commonly mislead managers are excessive optimism, overconfidence, confirmation bias (screening out data that doesn’t support a business case), and the illusion of control.

Heuristics are rules of thumb, or mental shortcuts, used to make decisions. They predispose users to bias. Among those discussed in the book are representativeness, or stereotypic thinking; availability, or relying overmuch on readily available information; and anchoring and adjustment, or becoming fixated on particular numbers, or “anchors.” There are valuation heuristics, too: the P/E, PEG, and price-to-sales heuristics rely on common financial ratios to provide cruder alternatives to the more rigorous discounted-cash-flow approach. And when managers make decisions based on instinct or intuition, they’re simply using another shortcut, the “affect heuristic.”

Finally, framing effects refer to how the settings for decision making are described: the manner of the description can influence the decision. All of these phenomena can and do combine to produce bad financial decisions, says Shefrin. His book provides numerous examples, such as:

• Why did Sony managers wait so long to pull the plug on a disastrous color-television venture in the 1960s? Shefrin thinks they fell prey to a bias called aversion to a sure loss, which, when combined with framing, leads to the “sunk cost fallacy.” The managers’ fear of failure led them to throw good money after bad.

• Why did Merck keep its debt levels low in the 1980s and 1990s and thus forgo significant tax benefits? Shefrin suggests that Merck executives were overly loss averse, perhaps due to a reluctance to court financial distress and so lose its top scientists and managers.

• Why did Enron’s board approve the partnerships that allowed CFO Andrew Fastow to play shell games with debt? Because the partnerships were presented (framed) as earnings tools, posits Shefrin, and because the board was prone to groupthink, with a history of mostly unanimous decisions.

• Why did Sun Microsystems CEO Scott McNealy aggressively invest in new projects in the teeth of the last economic downturn, investments that led to Sun’s decline? McNealy was afflicted with a host of biases, says Shefrin, including overconfidence, excessive optimism, confirmation bias, and illusion of control.

Opening Minds

Behavioral Corporate Finance offers cures as well as diagnoses, in the form of brief “debiasing” sections. For example, to ward off the reluctance to terminate failing projects, the book lists five questions that managers should ask, including “Can I clearly define what would constitute failure or success for this project?” and “If I took over my job for the first time today and found that this project was under way, would I support it or terminate it?”

Some readers might criticize the book’s case studies as being overly speculative. After all, how can we know from news articles whether a CFO was truly under the sway of a bias?

Responds Shefrin: “The cases are, for the most part, representative of an empirical body of work that looks at fairly large data sets. They are intended to help understand an underlying phenomenon that’s been empirically documented.” In any given case, he concedes, “it’s always possible that the person was acting in a way consistent with rational decision making.” But the probability that biases drove the person’s behavior is “high,” he adds. (Unlike standard texts, Shefrin’s book frequently considers what managers associated with a project actually had to say about it.)

Shefrin emphasizes that he is not trying to replace one dogma of corporate finance with another. “I want people to think about the range of alternative explanations, and put the behavioral one on the table,” he says. “I want to get people to be open-minded.”

Edward Teach is articles editor of CFO.