Role of Behavioral Economics in Business Decision-Making Process Essay

Excerpt from Essay :

Behavioral Economics

Many academics advocate that markets are "efficient." They argue that all stock and business information is embedded in the current price of an asset. As new information enters the market, the asset price immediately adjusts to reflect the new market sentiment. As a result of these efficient markets, investors can only hope to achieve the market rate of return given the amount of risk taken. There is very little opportunity, according to the academics to achieve higher rates of return in regards to capital expenditures than the overall market warrants. It is my contention however that the markets are inefficient in both valuations and subsequent reappraisals of assets and capital projects. Behavior finance and the teachings embedded within its theories are proof of the inefficient market theory (Shleifer, 1999). In fact, behavioral economics has very profound implications on the overall business decisions of a company in regards to growth. Through behavior finance companies can take advantage of extreme market pessimism to achieve higher rates of return without a subsequent increase in risk.

Topic 1

Corporate finance, budgeting and financial planning has arguably the most impact on the overall behavioral economics field. Our current economic climate provides a prime example of behavioral economics impacting business decisions. To begin, the overall behavioral economics field is the study of social, cognitive and emotional factors imbedded within a financial decision making process. The market is primarily composed of human beings making financial decision for themselves, their companies, or on an individual's behalf. As such, emotions play a very important role in regards to business decision making. By virtue of being human, emotions can cloud otherwise rational judgment in regards to financial decision making. These emotions can have a positive or adverse effect on business operations. For example, let's examine the financial services industry. Arguable the greatest crisis to occur within our lifetime was during the 2007-2008 fiscal year. During this year, stock prices plummeted nearly 50%, America encountered record unemployment, foreclosures were at all-time highs, and the global economy was in shambles. During this period it was very difficult for the average consumer to be the slightest bit optimistic about the future prospects of America. In fact, extreme pessimism was the majority sentiment at the time. These emotions directly correlate to financial planning and behavioral economics. Due to the extreme pessimism that prevailed during these periods, companies who were financial strong had opportunities to acquire other firms. JP Morgan acquired Washington Mutual and Bear Sterns for pennies on the dollar due to pessimistic emotions. Wells Fargo was able to acquire Wachovia as the market emotions depressed prices to bargain levels. Stocks of financially stable companies with fortress balance sheets, such as Wal-Mart, Proctor & Gamble, and Nike, were all trading at very depressed prices. The emotions of behavior finance provided opportunities in regards to financial planning and budgeting. If the typical retail investor planning and budgeting for retirement bought stock in the depths of 2008, the individual would have doubled his initial investment by 2012. The emotions of behavior finance provided opportunities for businesses and individuals to profit.

Topic 2

Mergers and acquisitions, as mentioned briefly in the financial services industry example above, also are impacted by behavioral economics. Mergers and acquisitions often fail due to over optimism on the part of management. These emotions, both social and cognitive, impact the success of mergers and acquisitions. Emotions, and in particular, hubris on the part of management effects the success of mergers and acquisitions. Hubris, when used appropriately provides the confidence and courage to undertake acquisitions. It also provides the conviction to stick with those acquisitions if it is believed to be profitable. Hubris can also be a detriment to business operations as I mentioned earlier. Too much hubris can create an atmosphere of acquisitions simply for the sake of acquiring the firm. Management due to emotions desires the satisfaction of managing a larger domain with more complexity. This is usually at the expense of shareholders who often are entrusting their future cash flow to the CEO. 70% of mergers fail to result in their intended profit and cash flow forecasts. This is due primarily to the issues I mentioned above. As such, the CEO must proceed with caution in regards to his or her emotional state when conducting a merger. Behavioral economics in regards to market sentiments also impacts M&A activity overall. During periods of mass optimism, the valuations placed on firms dramatically increases. As such the costs to acquire the firm is steep relative to its intrinsic value. As is often the case, companies pay extreme premiums over what the company is actually worth in order to obtain the firm. In this instance behavior finance again impacts decisions and clouds judgment. The vast majority of the 70% failure rate of mergers is due to the overvaluation placed on the firm. Numerous examples including the failed merger of AOL and Time Warner, and the complete write off of Microsoft's search engine acquisition are examples of this. This overinflated figure is often used as a ploy in the negotiation proceedings. The target firm wants to benefit the owner, or in this instance, the shareholders in the most beneficial manner. By overinflating the value of the firm initially, the target firm can then wager the price down. This seems like a concession on the part of the target firm, when in reality the firm did not intend to receive the overinflated price in the first place. This process results in the acquiring firm, believing that it has obtained a bargain, to dramatically over pay for the target firm. After many years of struggle, the acquiring firm usually takes a goodwill impairment to reflect the true value of the acquired firm.

Topic 3

Finally, behavioral economics impacts both business management and strategic marketing. Much like many of the example mentioned above, behavioral economics has a profound impact on management decision making. We need not look any further than our current economic circumstances to provide evidence of this. Currently, unemployment in America has been above the 8% mark for the past 36 months. Pundits are quick to site the sluggish recovery, modest gains in housing, and an ever evolving European debt crisis as the main culprits of this prolonged stagnation. In addition to these notions, behavioral economics is also impacting the labor market as emotions continue to weigh down on management decision making. Management, due primarily to economic uncertainty are fearful of the future. They fear catastrophe abroad. They fear a potential double dip recession. They fear the rapidly approaching fiscal cliff that could unravel any potential recovery in America. As a result of this emotion, and the prevailing social sentiments in the market, management is therefore reluctant to hire. As such the unemployment rate has been elevated for the past three years. Demand, as management currently determines, does not warrant a subsequent increase in personnel. Management due to often misinformed pessimistic framing would rather wait to hire personnel. Even more alarming, management of major firms is investing heavily in technology as oppose to humans. Technology due to the low interest rate environment is easier to acquire, service, and maintain as oppose to humans, who are often undependable and sporadic in their behaviors. Management due to the framing of issues abroad is therefore contributing to the slow growth environment the work is currently in. Behavior economics, in this example is impacting the strategic decision to hire within the context of the American society. In regards to positioning, companies are positioning themselves in a more conservative manner reflecting once again the extreme pessimism of the market. Companies are cutting benefits, hiring less, lowering wages, cutting hours, and are more cost conscious as a result of the macroeconomic environment. To venture back to the banking examples mentioned throughout…

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