Ch. 4: Behavioral Corporate Finance 155
2.3. Investment policy
Of paramount importance are the real consequences of market inefficiency. It is one
thing to say that investor irrationality has an impact on capital market prices, or even
financing policy, which lead to transfers of wealth among investors. It is another to say
that mispricing leads to underinvestment, overinvestment, or the general misallocation
of capital and deadweight losses for the economy as a whole. In this subsection we
review research on how market inefficiency affects real investment, mergers and acqui-
sitions, and diversification.
2.3.1. Real investment
In the rational managers, irrational investors framework, mispricing influences real in-
vestment in two ways. First, investment may itself be a characteristic that is subject
to mispricing (δK >0 above). Investors may overestimate the value of investment in
particular technologies, for example. Second, a financially constrained firm (fe > 0
above) may be forced to pass up fundamentally valuable investment opportunities if it
is undervalued.
Most research has looked at the first type of effect. Of course, anecdotal evidence of
this effect comes from bubble episodes; it was with the late 1920s bubble fresh in mind
thatKeynes (1936)argued that short-term investor sentiment is, at least in some eras,
a major or dominant determinant of investment. More recent US stock market episodes
generally viewed as bubbles include the electronics boom in 1959–1962, growth stocks
in 1967–1968, the “nifty fifty” in the early 1970s, gambling stocks in 1977–1978, nat-
ural resources, high tech, and biotechnology stocks in the 1980s, and the Internet in the
late 1990s; seeMalkiel (1990)for an anecdotal review of some of these earlier bubbles,
andOfek and Richardson (2003)on the Internet. SeeKindleberger (2000)for an attempt
to draw general lessons from bubbles and crashes over several hundred years, and for
anecdotal remarks on their sometimes dramatic real consequences.
The first modern empirical studies in this area asked whether investment is sensitive
to stock prices over and above direct measures of the marginal product of capital, such
as cash flow or profitability. If it is not, they reasoned, then the univariate link between
investment and stock valuations likely just reflects the standard, efficient-marketsQ
channel. This approach did not lead to a clear conclusion, however. For example,Barro
(1990)argues for a strong independent effect of stock prices, whileMorck, Shleifer, and
Vishny (1990b)andBlanchard, Rhee, and Summers (1993)conclude that the incremen-
tal effect is weak.
The more recent wave of studies has taken a different tack. Rather than controlling for
fundamentals and looking for a residual effect of stock prices, they try to proxy for the
mispricing component of stock prices and examine whether it affects investment. In this
spirit,Chirinko and Schaller (2001, 2006), Panageas (2004), Polk and Sapienza (2004),
andGilchrist, Himmelberg, and Huberman (2005)all find evidence that investment is
sensitive to proxies for mispricing. Of course, the generic concern is that the mispricing