168 M. Baker et al.
dynamic speculative market ofScheinkman and Xiong (2003), in which two groups of
overconfident investors trade shares back and forth as their relative optimism fluctuates.
The share price in this market contains a speculative option component, reflecting the
possibility that nonholders might suddenly become willing to buy at a high price. Bolton
et al. find that the optimal contract may induce the CEO to take costly actions that ex-
acerbate differences of opinion, thus increasing the value of the option component of
stock prices, at the expense of long-run value.
- The irrational managers approach
The second approach to behavioral corporate finance takes the opposite extreme, in
which irrational managers operate in efficient capital markets. To be more precise, by
irrational managerial behavior we mean behavior that departs from rational expectations
and expected utility maximization of the manager. We are not interested in rational
moral hazard behavior, such as empire building, stealing, and plain slacking off. Instead,
we are concerned with situations where the manager believes that he is actually close
to maximizing firm value—and, in the process, some compensation scheme—but is in
fact deviating from this ideal.^18
As in the irrational investors approach, an extra building block is required. In order
for less-than-fully-rational managers to have an impact, corporate governance must be
limited in its ability to constrain them into making rational decisions. In general, an
assumption of limited governance seems like a reasonable one to maintain. Takeover
battles and proxy fights are notoriously blunt tools. Boards may be more a part of the
problem than the solution if they have their own biases or are pawns of management.
And unlike in a traditional agency problem, which arises when there is a conflict of
interest between managers and outside investors, standard incentive contracts have little
effect: an irrational manager may well think that he is maximizing value. Finally, in the
US, a significant element of managerial discretion is codified in the business judgment
rule. SeeAdams, Almeida, and Ferreira (2005)andBertrand and Schoar (2003)for
direct evidence that managers have discretion, andShleifer and Vishny (1997)for a
broader review of corporate governance institutions.
The psychology and economics literatures relevant to managerial behavior are vast.
For us, the main themes are that individuals do not always form beliefs logically, nor
do these beliefs convert to decisions in a consistent and rational manner—seeGilovich,
Griffin, and Kahneman (2002)andKahneman and Tversky (2000)for collected works.
Thus far, most research in corporate finance has focused on the positive illusions of op-
timism and overconfidence. Illustrating the pattern of optimism,Weinstein (1980)finds
in overvalued equity, in the form of options grants.Benartzi (2001)offers a foundation for this sort of op-
timism, showing that employees have a tendency to extrapolate past returns, and as a consequence hold too
much company stock. See alsoCore and Guay (2001)andOyer and Schaeffer (2005).
(^18) Our focus is on corporate finance decisions.Camerer and Malmendier (2005)discuss the impact of less
than fully rational behavior in other parts of organizations.