148 M. Baker et al.
The second approach to behavioral corporate finance, the “irrational managers ap-
proach”, is less developed at this point. It assumes that managers have behavioral biases,
but retains the rationality of investors, albeit limiting the governance mechanisms they
can employ to constrain managers. Following the emphasis of the current literature, our
discussion centers on the biases of optimism and overconfidence. A simple model shows
how these biases, in leading managers to believe their firms are undervalued, encour-
age overinvestment from internal resources, and a preference for internal to external
finance, especially internal equity. We note that the predictions of the optimism and
overconfidence models typically look very much like those of agency and asymmetric
information models.
In this approach, the main obstacles for empirical tests include distinguishing pre-
dictions from standard, non-behavioral models, as well as empirically measuring man-
agerial biases. Again, however, creative solutions have been proposed. The effects of
optimism and overconfidence have been empirically studied in the context of merger
activity, corporate investment-cash flow relationships, entrepreneurial financing and in-
vestment decisions, and the structure of financial contracts. Separately, we discuss the
potential of a few other behavioral patterns that have received some attention in corpo-
rate finance, including bounded rationality and reference-point preferences. As in the
case of investor irrationality, the real economic losses associated with managerial irra-
tionality have yet to be clearly quantified, but some evidence suggests that they are very
significant.
Taking a step back, it is important to note that the two approaches take very different
views about the role and quality of managers, and have very different normative impli-
cations as a result. That is, when the primary source of irrationality is on the investor
side, long-term value maximization and economic efficiency requires insulating man-
agers from short-term share price pressures. Managers need to be insulated to achieve
the flexibility necessary to make decisions that may be unpopular in the marketplace.
This may imply benefits from internal capital markets, barriers to takeovers, and so
forth. On the other hand, if the main source of irrationality is on the managerial side,
efficiency requires reducing discretion and obligating managers to respond to market
price signals. The stark contrast between the normative implications of these two ap-
proaches to behavioral corporate finance is one reason why the area is fascinating, and
why more work in the area is needed.
Overall, our survey suggests that the behavioral approaches can help to explain a
range of financing and investment patterns, while at the same time depend on a relatively
small set of realistic assumptions. Moreover, there is much room to grow before the field
reaches maturity. In an effort to stimulate that growth, we close the survey with a short
list of open questions.
- The irrational investors approach
We start with one extreme, in which rational managers coexist with irrational investors.
There are two key building blocks here. First, irrational investors must influence secu-