Abstract: Sunk costs are unrecoverable costs that should not affect decision-making. I provide evidence that firms systematically fail to ignore sunk costs and that this leads to significant distortions in investment decisions. In fixed exchange ratio stock mergers, aggregate market fluctuations after parties enter into a binding merger agreement induce plausibly exogenous variation in the final acquisition cost. These quasi-random cost shocks strongly predict firms' commitment to an acquired business following deal completion, with an interquartile cost increase reducing subsequent divestiture rates by 8-9%. Consistent with an intrapersonal sunk cost mechanism, distortions are concentrated in firm-years in which the acquiring CEO is still in office. Further tests reveal that excessive commitment triggered by sunk costs generates substantial real effects and erodes firm performance.
Abstract: We show that increased job demands due to takeover threats and industry crises have significant adverse consequences for managers’ long-term health. Using hand-collected data on the dates of birth and death for more than 1,600 CEOs of large, publicly-listed U.S. firms, we estimate that CEOs’ lifespan increases by around two years when insulated from market discipline via anti-takeover laws. Longevity diminishes when job demands increase because of industry-wide downturns during a CEO's tenure. These estimates are not driven by differences in tenure. We then utilize machine-learning age-estimation methods to detect visible signs of aging in pictures of CEOs. We estimate that exposure to a distress shock during the Great Recession increases CEOs' apparent age by roughly one year over the next decade.
Marius Guenzel and Ulrike Malmendier (2020), Behavioral Corporate Finance: The Life Cycle of a CEO Career, Oxford Research Encyclopedia of Economics and Finance, forthcoming.
Abstract: One of the fastest-growing areas of finance research is the study of managerial biases and their implications for firm outcomes. Since the mid-2000s, this strand of behavioral corporate finance has provided theoretical and empirical evidence on the influence of biases in the corporate realm, such as overconfidence, experience effects, and the sunk-cost fallacy. The field has been a leading force in dismantling the argument that traditional economic mechanisms — selection, learning, and market discipline — would suffice to uphold the rational-manager paradigm. Instead, the evidence reveals that behavioral forces exert a significant influence at every stage of a chief executive officer’s (CEO’s) career. First, at the appointment stage, selection does not impede the promotion of behavioral managers. Instead, competitive environments oftentimes promote their advancement, even under value-maximizing selection mechanisms. Second, while at the helm of the company, learning opportunities are limited, since many managerial decisions occur at low frequency, and their causal effects are clouded by self-attribution bias and difficult to disentangle from those of concurrent events. Third, at the dismissal stage, market discipline does not ensure the firing of biased decision-makers as board members themselves are subject to biases in their evaluation of CEOs. By documenting how biases affect even the most educated and influential decision-makers, such as CEOs, the field has generated important insights into the hard-wiring of biases. Biases do not simply stem from a lack of education, nor are they restricted to low-ability agents. Instead, biases are significant elements of human decision-making at the highest levels of organizations. An important question for future research is how to limit, in each CEO career phase, the adverse effects of managerial biases. Potential approaches include refining selection mechanisms, designing and implementing corporate repairs, and reshaping corporate governance to account not only for incentive misalignments but also for biased decision-making.
This course combines insights from behavioral economics and psychology to shed light on anomalous decisions by investors and possibly behavior of asset prices. Its content is designed to both complement and challenge the “rational” investment paradigms developed in the early finance classes. It introduces students to much modern theoretical and empirical research showing this paradigm to be insufficient to describe various features of actual financial markets. The course structure involves early lectures, several cases, and a final project involving “real life” examples and some modern research methods. In the capstone project students research and explore a specific behavioral bias or a profitable investment opportunity. Students will work in groups to simulate the behavior of, say: a portfolio management team looking for a new trading strategy; a consulting firm advising corporations on issues of financial management; or an entrepreneurial start-up developing a retail financial product. The main deliverable is in a form of a “pitch” to potential clients to be delivered both in the form of a group presentation in class and a formal write-up to be submitted by the due date. Completion of FNCE 203 and FNCE 205 is recommended.