Behavioral Corporate Finance: The Life Cycle of a CEO Career

Marius Guenzel is Assistant Professor of Finance at the Wharton School of the University of Pennsylvania and Ulrike M. Malmendier is Edward J. and Mollie Arnold Professor of Finance at University of California Berkeley Haas School of Business, and Professor of Economics at the University of California Berkeley. This post is based on their recent paper.

The study of managerial biases and their implications for firm outcomes is one of the fastest-growing research areas in finance. Since the mid-2000s, this strand of behavioral corporate finance has provided ample theoretical and empirical evidence on the influence of biases in the corporate realm. Research in this field has been a leading force in dismantling the argument that traditional economic mechanisms—(1) selection, (2) learning, and (3) market discipline—are sufficient to uphold the rational-manager paradigm.

In Behavioral Corporate Finance: The Life Cycle of a CEO Career (Oxford Research Encyclopedia of Economics and Finance, September 2020), we review and analyze the growing body of research in the field. We structure our discussion according to three distinct phases of CEO careers: appointment, being at the helm, and dismissal. A key contribution of our paper is the insight that each phase of this CEO career life cycle is closely linked to one of the three aforementioned pillars of the rational-manager paradigm.

With regard to CEO appointment, the rational-manager argument is that corporate executives are not a random subsample of the population; they are smart, highly educated, and selected, and therefore presumed not to be susceptible to the biases of consumers and investors. In fact, early behavioral research focused exclusively on biases among these actors (e.g. Barber and Odean 2000, Lamont and Thaler 2003). Successful C-level managers were thought to be immune to these psychological forces or, if anything, to exploit the biases of investors by timing the market (Baker and Wurgler 2000, Baker, Stein, and Wurgler 2003). However, subsequent work has uncovered how biases distort decision-making at the very top. Moreover, this research has helped to clarify that selection into top managerial positions does not impede the promotion of behavioral managers. To the contrary, competitive environments oftentimes promote their advancement, even under value-maximizing selection mechanisms (e.g. Goel and Thakor 2008). Additionally, managerial self-selection and manager-firm assortative matching, such as overconfident managers matching with high-growth and highly levered firms, contribute to the prevalence of behavioral biases among CEOs as well as their cross-sectional variation.

With regard to the CEO being at the helm, the traditional argument is that while managers may make occasional mistakes, they are presumed to learn, update rationally, and optimize going forward. In sharp contrast to this, a convincing body of evidence documents systematic and persistent biases in managerial decision-making, such as overconfidence (e.g. Malmendier and Tate 2005, 2008), experience effects (e.g. Malmendier, Tate, and Yan 2011, Dittmar and Duchin 2015, Schoar and Zuo 2017), and the sunk-cost fallacy (Guenzel 2020). Factors limiting learning and de-biasing in the context of top-level decisions include the fact that many measurable corporate decisions tend to occur at low frequency (e.g. mergers and acquisitions). Additionally, the causal effects of managers’ decisions are clouded by self-attribution bias and are difficult to disentangle from those of concurrent events. Our analysis highlights that biased decision-making spans all decision areas in firms, from investment, M&A, and cross-segment capital allocation, to financing decisions including leverage, new issuances, and payout policy. The latest behavioral research also highlights the importance of taking into account the CFO’s biases in the context of financing decisions (Ben-David, Graham, and Harvey 2013, Boutros, Ben-David, Graham, Harvey, and Payne 2020, Malmendier, Pezone, and Zheng 2020), leading the way toward a comprehensive behavioral approach that considers C-suite joint decision-making.

With regard to CEO dismissal, the rational-manager argument rests on the idea that managers are closely monitored by corporate boards and the market, which is thought to keep any bias-driven errors at bay. However, market discipline does not ensure the firing of biased decision-makers. For one, distinguishing between causality versus correlation of managerial decisions and outcomes is difficult, which impedes board interventions and market correctives. Moreover, it is plausible that other relevant parties are themselves subject to biases in their evaluation of and performance attribution to CEOs. As we discuss, there is some work that studies optimal incentive contracts when managers are biased (e.g. Gervais, Heaton, and Odean 2011). Research that explores how other governance mechanisms can curb adverse effects of managerial biases is still in its infancy. A first step in this direction is the analysis in Banerjee, Humphery-Jenner, and Nanda (2015), who find that after improvements in corporate governance (Sarbanes-Oxley Act), overconfident CEOs reduce investment and use the freed-up cash flow to raise dividends. Similarly, more research is warranted on the potential biases and mistakes in boards’ judgment and evaluation of CEO performance.

In the paper, we also emphasize how the field of behavioral corporate finance, by documenting the influence of biases on even the most educated decision-makers such as CEOs, has generated important insight into the “hard-wiring” of biases. With CEOs typically having decades of professional experience prior to attaining the top-level position, and oftentimes in various firms and industries, it is evident that 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, even at the highest levels of organizations.

Throughout, we identify promising avenues for future research and discuss policy implications and managerial advice. One important question for future work is how to limit, in each CEO career phase, the adverse effects of managerial biases. Despite the abundance of evidence on managerial biases, surprisingly little is known about how to effectively curb biased decision-making in organizations. Potential approaches, which we explore further in the paper, 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. Encompassing many of the open questions that we discuss in the article, a key challenge for the field is to cultivate a comprehensive “behavioral approach” which recognizes that all parties involved are possibly subject to biases.

The complete paper is available here.

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