Behavioral Corporate Finance

17 Pages Posted: 23 Oct 2001

See all articles by Hersh Shefrin

Hersh Shefrin

Santa Clara University - Leavey School of Business


Managers and corporate directors need to recognize two key behavioral impediments that obstruct the process of value maximization, one internal to the firm and the other external. I call the first obstruction behavioral costs. Behavioral costs, like agency costs, tend to prevent value creation. Behavioral costs are the costs associated with errors that people make because of cognitive imperfections and emotional influences. The second obstruction stems from behavioral errors on the part of analysts and investors. These errors can create gaps between fundamental values and market prices. When they do, managers may find themselves conflicted, unsure of how to factor the errors of analysts and investors into their own decisions.

Proponents of value based management emphasize that with properly designed incentives, managers will maximize the value of the firms for which they work. As such, either they treat behavioral costs as simply another form of agency costs, or they deny the relevance of cognitive errors. In contrast, proponents of behavioral finance argue that behavioral costs are typically large, and cannot be addressed though incentives alone. This is not to say that incentives are immaterial. On the contrary, incentives are of critical importance. The point, however, is that there are limits to incentives. If employees have a distorted view of what is in their own self-interest, or if they have a mistaken view of what actions they need to take in order to maximize their self-interest, then incentive compatibility, although necessary for value maximization, will not be sufficient.

JEL Classification: G3

Suggested Citation

Shefrin, Hersh, Behavioral Corporate Finance. Journal of Applied Corporate Finance, Vol. 14, No. 3, Fall 2001. Available at SSRN: or

Hersh Shefrin (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Dept. of Finance
Santa Clara, CA 95053
United States
408-554-6893 (Phone)
408-554-4029 (Fax)

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