Another domain in which investor behavior can be observed is in their
defined contribution savings plans such as 401(k)s. In Chapter 16 Benartzi
and I investigate how investors handle diversification in such plans. We
show that investors have very naïve notions of diversification, and at least
some investors behave as if they were choosing funds from their plan at
random. This implies that when plan sponsors add new funds to the plan,
they inadvertently induce participants to alter their asset allocation.
VI. Corporate FinanceThe final section of the book concerns corporate finance, another new di-
rection for behavioral finance researchers. In Chapter 17 Jeremy Stein starts
the ball rolling on an important question: How should firms behave if mar-
ket efficiency is no longer taken for granted? Specifically, professors of cor-
porate finance have been teaching their students to use the CAPM beta to
determine hurdle rates for corporate investments; what should they be
teaching now if beta is dead? This is a tough problem, but Stein makes a
good start at thinking about it. He shows that factors such as time horizon
and financial constraints come into play in determining how a firm should
handle this problem.
In Chapter 18, Francois Degeorge, Jayendu Patel, and Richard Zeck-
hauser (DPZ) document some corporate behavior of the unsavory kind.
Just as Shleifer and Vishny’s paper on limits to arbitrage foretold the melt-
down of some hedge funds, DPZ offers an eerie warning of future headlines
in their essay on earnings manipulations. The authors hypothesize that
management has certain earnings targets that serve as salient aspiration lev-
els for themselves, their shareholders, and the analysts that follow the
stock. In particular, DPZ suggest three particularly important goals: make a
profit, make more than last year, and beat the analyst’s forecasts. They then
show that the distributions of reported earnings display odd discontinuities
at precisely the points suggested by the threshold model. For example, firms
are much more likely to make a penny more a share than last year than a
penny less. Since Enron, we now know that such earnings manipulations
can, at least occasionally, be just the small tip of a big iceberg.
Finally, in the last chapter of the book, J. B. Heaton approaches corpo-
rate finance from a different behavioral perspective. In Chapter 19 he starts
by assuming that markets are efficient and then asks how much of the em-
pirical literature in corporate finance can be understood by using one be-
havioral assumption about managers: optimism. He shows that much of
what we know about corporate behavior can be explained with this one as-
sumption (as opposed to rational models based on asymmetric information
and/or agency costs).
xvi THALER