Chapter 2 – Introduction to Behavioral Analysis
Chapter Two
Introduction to Behavioral Analysis
OVERVIEW
Chapter 1 introduced students to 10 key psychological phenomena that serve as
foundation concepts for the behavioral approach to corporate finance. This chapter
provides students with an opportunity to apply these concepts through behavioral
LEARNING OBJECTIVES
The main objective of the chapter is for students to demonstrate that they can use
the 10 psychological phenomena to analyze specific cases in corporate finance. The three
specific learning objectives for the chapter are that students be able to:
1. Identify the key biases that lead managers to make faulty financial judgments
about risky alternatives.
Chapter 2 – Introduction to Behavioral Analysis
these categories are the backbone concepts involved in the behavioral approach.
Instructors can then indicate that the 4 biases, 4 heuristics, and 2 framing effects
Because Exhibit 2-1 is a summary table, at this point there is no need to go into
detail about all entries. Instructors might find it useful to give one example from the
table, such as the line pertaining to excessive optimism. In this regard, instructors might
indicate that the first bias discussed in the course is known as excessive optimism, and
Psychological phenomena often generate obstacles that interfere with managers’
abilities to make value maximizing decisions. Because psychologically induced mistakes
can be, and often are, very expensive, studying behavioral corporate finance is vital.
Analyzing Biases: Illustrative Example, Sun Microsystems
A series of articles that appeared in the publication BusinessWeek apply a series
of adjectives to Scott McNealy, the chief executive officer of Sun Microsystems. These
adjectives correspond to some of the main psychological traits that are part of the
Chapter 2 – Introduction to Behavioral Analysis
attendant consequences of those decisions for value. Instructors might want to remind
students that the objective of the chapter is to provide a vehicle to discuss the application
The discussion about Sun Microsystems and Scott McNealy focuses on biases and
heuristics. A good way to undertake behavioral analysis is to structure questions to
identify the presence of particular psychological phenomena, asking if there is evidence
The case of Sun Microsystems, and Scott McNealy, was also discussed in the first
edition of the book, published over ten years before the second edition. The period
subsequent to the publication of the first edition provides an opportunity to examine the
impact of psychological phenomena discussed in the first edition on the performance of
Fortune magazine, a year after Sun was no longer a standalone company. Instructors can
draw attention to the discussion about this interview (on p. 44). Instructors might wish to
draw students’ attention to the interview, without dwelling on its details before students
have had an opportunity to analyze it on their own.
Chapter 2 – Introduction to Behavioral Analysis
Analyzing Biases: Illustrative Example, Merck & Co.
Illustrations of the two framing effects introduced in Chapter 1are provided using
behavior at the firm Merck & Co. As in the case of Sun Microsystems, instructors might
wish to remind students that the objective is to introduce behavioral concepts through
some illustrative examples, not to overanalyze upper level executives at Merck.
The discussion of decisions made at Merck focuses on its debt policy and the
manner in which it sold a particular drug, Vioxx, on the market. As with Sun
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might begin by
emphasizing to students that this book is a complement to their traditional corporate
The preceding general point comprises two parts. The first part involves the
nature of the corporate financial decisions that managers make, this being the focus of the
traditional approach to corporate finance. Instructors might remind students briefly what
these decisions entail.
Chapter 2 – Introduction to Behavioral Analysis
The second part involves psychological phenomena. In making the general point
that specific psychological phenomena are obstacles along the way to value
The most important column in Exhibit 1-1 is the left-most column. Instructors can
point to the three categories, namely biases, heuristics, and framing effects, noting that
these categories are the backbone concepts involved in the behavioral approach.
Because Exhibit 1-1 is a summary table, at this point there is no need to go into
detail about all entries. Instructors might find it useful to give one example from the
table, such as the line pertaining to excessive optimism. In this regard, instructors might
indicate that the first bias discussed in the course is known as excessive optimism, and
Chapter 2 – Introduction to Behavioral Analysis
Slide 7
Slide 7 describes the main points in the Behavioral Pitfalls box about Sun CEO
Scott McNealy. This box provides the backdrop for the discussion about biases and
heuristics. Instructors might indicate the behavioral traits attributed to McNealy in the
BusinessWeek article, and then point to the behaviors mentioned in the article about
Slide 8
Instructors can draw attention to the first behavioral bias, excessive optimism, a
concept illustrated in slide 8. In this illustration, Scott McNealy was excessively
optimistic about the 2001 recession being short, and delayed cost cutting at Sun as a
Slide 9
Slide 3 illustrates what appears to have been excessive optimism by investors
about the value of Sun stock from late 1998 through the second half of 2000.
Chapter 2 – Introduction to Behavioral Analysis
Slide 10
Managers can be overconfident about both their own abilities and their
knowledge. Instructors might ask students to volunteer which adjective mentioned in the
Slide 11
Slide 11 illustrates overconfidence about knowledge, using as an example
McNealy’s strongly held view that the 2001 recession would be much shorter and sharper
than past recessions. Instructors might ask students for their opinions about how atypical
the recession of 2001 was, based on what they see portrayed in exhibit 1.3 displayed in
slide 5. The 0-point along the x-axis displays the first quarter during the period where
2001. However, the main point of the slide is that he was overconfident about his
knowledge of recessions, meaning he knew less than he thought he knew. Overconfident
people come to be surprised more frequently than they anticipated.
Chapter 2 – Introduction to Behavioral Analysis
Slide 12
Slide 6 illustrates confirmation bias, the tendency to overweight evidence that
confirms our views relative to information that disconfirms our views. The slide makes
Slide 13
Instructors might wish to ask students what the concept illusion of control means
to them. Such a question typically produces a response about people having less control
than they believe they have. Instructors might then amplify the statement to point out that
the outcome emanating from a given decision reflects luck as well as skill. The more
control a manager possesses, the greater the role skill plays relative to luck. Hence,
Slide 14
Slide 14 introduces the first heuristic principle, representativeness, the
overreliance on stereotypes. Instructors might wish to ask students to imagine how
representativeness might affect the thinking of someone like Scott McNealy, who thinks
Chapter 2 – Introduction to Behavioral Analysis
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classroom. No reproduction or further distribution permitted without the prior written consent of
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that the Internet is becoming increasingly important to the overall economy. Instructors
might ask students to ponder whether representativeness might incline someone like Scott
McNealy to view technology firms who make products that run the Internet as being
representative of the overall economy?
Slide 15
Slide 15 illustrates the concept of availability, the tendency to rely on information
that is easily available. Instructors might ask students whether Scott McNealy’s being
distracted by the Microsoft suit might make it difficult for him to give appropriate weight
to customers’ needs, in this case for low-end servers.
Slide 16
Slide 16 illustrates the concept anchoring and adjustment, and should be self-
explanatory. Anchoring on an abnormally high 50% growth, and adjusting down, is likely
Chapter 2 – Introduction to Behavioral Analysis
Slide 17
Slide 17 provides an example of the affect heuristic, the tendency to make
decisions by relying on intuition and gut instinct. Instructors might ask students what they
make of Sun CFO Michael Lehman’s remark about behaving differently than corporate
Slide 22
Slide 22 introduces the second Behavioral Pitfall box, this time in connection with
the pharmaceutical firm Merck, its CFO Judy Lewent, and its drug Vioxx. Instructors can
Slide 23
Slide 13 introduces the first of two framing effects, loss aversion. Loss aversion
involves being unduly sensitive to the possibility of loss, thereby overweighting potential
losses relative to potential gains. The example provided in slide 23 involves taking on too
Chapter 2 – Introduction to Behavioral Analysis
Slide 24
Slide 24 introduces the concept aversion to a sure loss. Instructors can emphasize
to students that aversion to a sure loss might sound like loss aversion, but is very
different. Aversion to a sure loss is the tendency to try and beat the odds in order to avoid
having to accept a sure loss. In the example, Merck’s managers had information early on
that suggested that Vioxx caused heart attacks and strokes. However, because several of
their blockbuster drugs were going off patent, they framed lower revenues as constituting
a sure psychological loss. Their decision to try and maximize Vioxx’s sales revenues, in
the face of information already at their disposal, suggests that they could not accept a sure
loss, and instead attempted to beat the odds and turn Vioxx into a blockbuster. Had they
Chapter 2 – Introduction to Behavioral Analysis
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classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
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influenced by the negative affect that they associated to Merck, and that the affect
heuristic played a role in their decision.
Slide 27
Slide 15 provides an example of a coprate nudge, the process of mitigating
susceptibility to psychological phenomena that tend to reduce value. The example in the
Additional Resources for Chapter 2 Available on the Web
On the web at www.mhhe.com/shefrin, instructors will find additional resources
that relate to Chapter 2. This material is intended for instructors who wish to delve into
Answer Key for Minicase Hurricanes and Psychology: From Wall Street of the
Southwest to the Big Easy
1. Identify which psychological phenomena described in the chapter played a role in
the Galveston disaster of 1900.
Chapter 2 – Introduction to Behavioral Analysis
ANSWER: The key psychological phenomena involved in the minicase about Galveston
are availability, excessive optimism, and overconfidence.
Excessive optimism and overconfidence: These traits were evident in Isaac Cline’s 1891
opinion about there being no need for Galveston to erect a sea wall. The language is
1. Compare the psychological traits and experiences of Isaac Cline with those of
Scott McNealy, chief executive officer of Sun Microsystems.
Chapter 2 – Introduction to Behavioral Analysis
ANSWER: Both Isaac Cline and Scott McNealy achieved early success in the face of
opposition. Cline had achieved success in accurately forecasting freezing weather
Those early successes might have encouraged overconfidence in both Cline and
McNealy, not to mention excessive optimism. Cline was certain that a cyclone could not
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
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