Impact of Behavioral Finance on Mergers and acquisitions

According to the traditional economics theory, managers are rational and their main objective
is to maximize the firm value as well as shareholders value. While this assumption is not
always true, a new field of economics, known as “Behavioral Finance”, challenges the
traditional theory. D. Kahneman and A. Tversky are considered as the fathers of behavioral
finance. The study of behavioral finance incorporates the theories of psychology, sociology
and biology in investment decisions. It states that human beings tend to show irrational
behavior as their decisions are subjected to cognitive and emotional illusion. This shift in
decision based on situation of uncertainty is known as behavioral bias. As per Amlan Jyoti
Sharma’s paper on Role of Behavioral Finance in the Financial Market, the four main concepts
of behavioral finance are cognitive dissonance, herd behavior, loss aversion and mental
accounting.

Apart from the relevance of behavioral finance in financial markets, stock market anomalies
and investment decisions, it plays a major role in mergers and acquisitions. Mergers and
Acquisitions are aimed at economic benefits like economies of scale and scope,
diversification, synergies, tax benefits and gains through horizontal and vertical M&As. As per
a 2015 KPMG study, as many as 83% of merger deals fail. Hence managers and CEOs are
expected to initiate only those deals which have a lower risk of failure. But this not being the
case, hubris or management ego plays a key role in driving M&A activity.

One of the major behavioral bias which leads to this decision by the managers is
overconfidence and excessive optimism as per research work by Roll (1980), Malmendier and
Tate (2002). Overconfidence is the outcome of self-attribution bias of the managers. Self-
attribution bias is an important concept of psychology research wherein an individual credits
one’s personal skills for one’s success and blames external factors for failure. Mangers
consider themselves superior in decision making and emphasize their decision on the
management. They underestimate the risks and overestimate the synergies in the M&A deals.

Confirmation or Familiarity bias plays a significant role in the M&A activity. According to a
book by Montier J. (2004) Insights into Irrational Mind and Markets, people tend to believe in
or agree with information that they are familiar with or about which they have existing pre-
conceptions.
Illusion of control is another behavioral factor which influences manager’s decision in M&A
activity. According to the research conducted by Kahneman and Tversky (1982), Roll (1986),
in this factor people tend to overestimate their control and feel that they can control the
consequences of actions which they actually have no influence over. Illusion of control can be
a result of overconfidence bias.

Availability of information is another cognitive bias where decision makers in a management

tend to accept the readily available information rather than spending time on gathering new
information. The study of the effect of this bias on the manager’s decision during M&A was
presented by Shefrin (2007).

Anchoring bias, as per Judgment under Uncertainty: Heuristics and Biases by Amos Tversky
and Daniel Kahneman, states that decision makers tend to begin with an initial value and
adjust it according to the new circumstances and situations to get the final result. Such biases
could be related to the valuation of M&As.

Affect heuristic, as per Behavioral Corporate Finance: Decisions that Create Value by Shefrin,
also affect M&A activity where the decision makers or the managers tend to make decisions
based on intuition, instinct and gut feeling. This can be related to overconfidence bias of the
managers where the decision to proceed with the deal is taken quickly without proper
planning and analysis.

Besides the above biases of behavioral finance, there are many others which influence the
decisions of the manager or CEO. Though ‘affect heuristic’- which is based on the emotion of
gut feeling- is a source of motivation to go ahead in the game of mergers and acquisitions, it
is only when managers or decision makers understand what mistakes they make or how their
behavior impacts them during decision making, can they make better decisions.

Anmol Tushar Raykar

Section 3, PGP1