Very broadly speaking, behavioral finance looks at the actions and reactions made by people in order to determine how to better understand them and make better decisions.
Here are few behaviors to keep in mind:
Making financial decisions is rarely entirely rational. Most economic models, financial and otherwise, assume that people act unemotionally and with a certain degree of competence, but in reality, people are emotional, illogical, impulsive, and ignorant. Behavioral finance defines what’s rational, identifies the causes of irrational financial behavior, and measures the financial impact of irrational behavior.
Making sound financial decisions involves identifying logical fallacies. Logic can be really complicated. When you rely on faulty logic, you’re relying on a fallacy. Logical fallacies can be based on flawed logic structure, distractions, emotional response, or any number of other factors that use information not related to the decision at hand.
Getting emotional about financial decisions can leave you crying. In the world of corporate finance, you’re typically dealing with someone else’s (the company’s) money, so you may think emotions run low in corporate finance. But no matter how far removed you are from the person who actually owns the money you’re working with, when you’re forced to make a decision, your mood and emotions will influence the decision you make to some extent.
Financial stampeding can get you trampled. As soon as some trend begins to occur, financial investors start to follow that trend as quickly as possible, often without even fully knowing why. Like some other forms of behavioral anomalies, this stampeding scenario is influenced by the imperfect distribution of information.
Letting relationships influence finances can be ruinous. Avoid showing favoritism based on personal relationships rather than merit or qualifications. This form of favoritism is called cronyism (or nepotism, when you’re dealing with relatives). Preventing cronyism from occurring in a company is relatively simple at all levels of management except the highest. You just have to require individuals to use predetermined evaluation criteria when making important decisions and then hold them accountable for proper recording and analysis using that criteria.
“Satisficing” can optimize your time and energy. People naturally apply a value to their time. This value isn’t so much about money as it is about using your limited amount of time doing things you either need to do or would rather be doing. For a simple example, imagine that you’re spending your day off playing video games, and you just can’t take time away to go cook dinner. So you decide to order a pizza. You could probably make something healthier, cheaper, and more delicious, but you settle for something that’s good enough and doesn’t require any additional time or effort on your part. In corporate finance, the application and measurement of what’s “good enough” is called satisficing.
Prospect theory explains life in the improbable. People’s financial decisions are influenced by a behavioral fluke described as the prospect theory, which basically says this:
When making financial decisions that aren’t certain (meaning that the outcomes aren’t certain but the probability of success can be estimated), people look at the potential for gain or loss instead of relying on rational thinking using the probable outcomes.
People are subject to behavioral biases. When you’re dealing with corporate finance, you rely on the collection and analysis of data to help you answer questions and make decisions. Even though all the data you need to make the best decision may be available, how you actually perceive and use that data can be an erroneous process thanks to statistical bias and cognitive bias.
Analyzing and presenting information can be an erroneous process. How a person processes available data is subject to behavioral errors based on the context in which the data are presented. The process of introducing your own interpretation of a subjective measure or event is called framing. These frames will cause you to understand and interpret things in a different manner from the people around you and, as a result, alter how you each respond.
Framing can influence all sorts of financial decisions. You have to be very careful to apply relevant contextual information along with any analysis you give and ensure that the manner in which you present information remains objective, neutral, and free of judgments that contribute to framing.
Measuring irrationality in finance is rational behavioral finance. Understanding how irrational financial behavior works is only half the job. You also have to determine the value of irrationality. That is to say, you must figure out how much your own inherent irrationality costs you (and your company) financially.
FAQs
Math skills
Corporate finance uses, more than anything else, a lot of math. The majority of it is quite simple, but it's still math, so corporate finance is particularly ideal for those who are numerically inclined.
Is corporate finance hard to learn? ›
Finance degrees are generally considered to be challenging. In a program like this, students gain exposure to new concepts, from financial lingo to mathematical problems, so there can be a learning curve.
What is the synopsis of corporate finance for dummies? ›
Brief summary
Corporate Finance for Dummies by Michael Taillard is a beginner's guide to understanding corporate finance. It covers essential concepts such as financial planning, investment decisions, and risk management, making it an ideal resource for those new to the subject.
What is corporate finance in simple terms? ›
Corporate finance is a branch of finance that focuses on how corporations approach capital structuring, funding sources, investments, and accounting decisions. Its primary goal is to maximize shareholder value while striking a balance between risk and profitability.
Is corporate finance harder than accounting? ›
Generally speaking, people consider accounting majors to be more difficult to study and pass than finance majors. And there are a few different reasons for this. The content of accounting majors is, on average, much more technical than for finance majors, and this can make it more difficult.
Can I do finance if I'm bad at math? ›
It's normal to have these thoughts and it's good to ask these kind of questions before you get into it. Believe it or not, mastery of advanced math skills is not necessary to have a career in finance. With today's technology, all math-related tasks can be done by computers and calculators.
What is the best way to learn corporate finance? ›
Universities offer free online courses on a myriad of financial topics. A subscription to a publication like The Wall Street Journal or Barron's, conversations with financial services professionals, and taking courses at the CFA Institute can all further your education.
What is the toughest course in finance? ›
The Chartered Financial Analyst (CFA) program is widely regarded as one of the toughest courses in finance. It requires an immense amount of dedication to successfully complete and the pass rate is notoriously low, making it a highly sought-after certification in the finance world.
Can you learn corporate finance on your own? ›
There are multiple ways you can learn about finance, including online courses, in-person classes, reading financial publications, self-teaching from finance books, and joining a network of financial professionals.
What are the three 3 principles of corporate finance? ›
Every discipline has first principles that govern and guide everything that gets done within it. All of corporate finance is built on three principles, which we will call, rather unimaginatively, the investment principle, the financing principle, and the dividend principle.
Corporate finance has three main areas: capital budgeting, capital financing, and working capital management. Capital budgeting is the process of prioritizing funds toward the most profitable projects. Capital financing is determining how a company's investments and endeavors will be financed.
What are the five basic corporate finance functions? ›
The five basic corporate functions are financing (or capital raising), capital budgeting, financial management, corporate governance, and risk management. These functions are all related, for example, a company needs financing to fund its capital budgeting choices.
What are the three main goals of corporate finance? ›
The primary objectives of corporate finance encompass maximising shareholder value, optimising capital structure, and ensuring efficient resource allocation.
Is corporate finance easy? ›
Corporate Finance Courses
Corporate finance is a “relatively competitive” field to get into. “Relatively competitive” means that it's easier than investment banking or equity research (for example), but also harder than most non-finance roles at large companies.
What are the three areas of corporate finance? ›
What Are The Three Main Areas Of Corporate Finance? Corporate finance is split into three sub-sections: capital budgeting, capital structure, and working capital management. Capital budgeting operates over the long term.
Is there a lot of math in finance majors? ›
While each program will vary slightly, students earning a finance degree can expect to take a sizable amount of math classes.
Is corporate finance stressful? ›
The median annual wage for business and financial occupations is $46,310 higher than the median annual wage for all occupations. Drawbacks of a career in finance can include high stress, long working hours, continuing education requirements, and, in some cases, limited job stability.
What is the hardest finance career? ›
Trader is one of the most stressful jobs in finance. Traders may not work quite the crazy hours of investment bankers, but they have a sharper, more acute level of stress.
Is corporate finance competitive? ›
Corporate finance is a “relatively competitive” field to get into. “Relatively competitive” means that it's easier than investment banking or equity research (for example), but also harder than most non-finance roles at large companies.
