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© Nathan Mandell
Nobel Prize Laureate and Princeton Psychology Professor Daniel Kahneman addresses the Kellogg School on the subject of behavioral economics during the May 2004 Nancy L. Schwartz Memorial Lecture.

Behave yourself!
Behavioral finance adds 'psychological realism' to an academic discipline with a reputation for embracing the theoretical

By Deborah Leigh Wood

Paola Sapienza and Christopher Polk don't consider themselves staunch supporters of behavioral finance, which rejects the popular efficient markets theory in favor of the belief that behavioral factors associated with decision-making can cause inefficiencies in financial markets. Nevertheless, these assistant professors of finance at the Kellogg School saw enough evidence of this relatively new theory to pique their interest in discovering whether market inefficiencies have influence on manager's real investment decisions, such as capital expenditure.

What they emerged with in their working research paper, "The Real Effects of Investor Sentiment," is that misvaluation of stock prices may influence capital investment. In other words, macroeconomic output can be distorted by inefficient stock markets.

The authors say their paper is controversial because it suggests new consequences when human error and/or market frictions allow stock prices to get out of whack. Behavioral finance, and more generally behavioral economics, does have its share of highly respected proponents, including Sapienza's adviser, Andrei Schleifer, professor of economics at Harvard University, and Daniel Kahneman, this spring's Nancy L. Schwartz Memorial Lecture speaker at the Kellogg School. Kahneman, professor of psychology and professor of public affairs at Princeton University, was named the 2002 Nobel Prize Laureate for his psychological insights into economic science.

Though applications in finance are relatively new, behavioral theories originated as long as 30 years ago, growing out of research into the influence of rewards and punishments on decision-making, conducted at The Hebrew University of Jerusalem.

Behavioral finance also has its detractors, chief among them Eugene Fama, who in the 1960s developed the "market knows best" theory at the University of Chicago—where he served as Polk's mentor.

"I haven't yet told him about the paper," Polk says with a wry smile.

While most behavioral finance research focuses on "who gains and who loses," says Sapienza, she and Polk wanted to know about "the real economic consequences" of overvalued and undervalued stock. Could a manager of an overvalued company invest in projects that rationally should be considered as negative net present value (NPV) but are temporarily in vogue by players in the stock market? Similarly, could managers of undervalued companies forgo positive NPV projects because the market is overly pessimistic about their prospects?

Their interpretation of anecdotal evidence concerning the online grocer Webvan drove Polk and Sapienza's early discussions about the real effects of investor sentiment. Early in its existence, each time that the startup announced the opening of another $25 million automated warehouse, its stock price increased. Only later did investors realize that that expensive technology did not automatically turn a questionable business model into a profitable enterprise, as evidenced by Webvan's bankruptcy in 2001, after a short shelf life of two years.

"A CEO may be concerned about stock prices in the short run, but in the long run [investing in negative NPV projects] destroys the company's value, hurting the economy," Sapienza says.

She and Polk found patterns in stock returns consistent with overpriced firms investing too much and underpriced firms not investing enough. Companies that had relatively low investment had stock returns that were subsequently high (after controlling for investment opportunities and other characteristics linked to return predictability). Companies (like Webvan) with relatively high investment subsequently underperformed. Sapienza points out that this evidence confirms a link between market inefficiencies and some of the most important decisions within firms, including "not only how a firm chooses its amount of physical capital but also how many people a firm employs and how a firm budgets R&D."

Polk says he and Sapienza believe most skeptics would at least grant that during the Internet bubble of the 1990s, many entrepreneurs built startups based on misleading measures, such as the number of projected Web clicks, rather than on justifiable financial analysis such as NPV. From that common ground, Polk hopes that these skeptics will consider their research as an attempt to see if similar mistakes occurred in other time periods.

The lesson for companies focused on the stock price in the short run, Sapienza says, is that eventually "the market catches up with you."

©2002 Kellogg School of Management, Northwestern University