Behavioral finance and corporate finance are both organized in the exact same way

Behavioral finance and corporate finance are both organized in the exact same way. Neither is based on a grand unified theory. Instead, both fields proceed by looking for deviations from a benchmark model. The behavioral-finance literature is a list of ways to violate market efficiency. The corporate-finance literature is a collection of ways to relax the assumptions needed for capital-structure irrelevance. Same setup.

One reason for writing this post is to spread the word about this symmetry. I don’t think it’s widely appreciated. Occasionally I’ll mention it to somebody. When I do, I usually get either a blank stare or a look of sudden recognition. I’d like to live in a world where the comment gets a bland nod in agreement.

I also think it’s noteworthy how differently each field is viewed within the profession given that both fields are calling plays from the same playbook. True, behavioral finance has not proposed an alternative to market efficiency. But, then again, ain’t nobody asking corporate researchers to come up with an alternative to ModiglianiMiller58. Highlighting this disconnect is the other reason for writing this post.

Behavioral finance

Behavioral economists explain market outcomes by pointing to deviations from market efficiency—i.e., the idea that “security prices fully reflect all available information”. In John Cochrane’s words: “Informational efficiency is a natural consequence of competition, relatively free entry, and low costs of information in financial markets. If there is a signal, not now incorporated in market prices, that future values will be high, competitive traders will buy. In doing so, they bid the price up until it fully reflects the available information.”

If there’s a signal that an asset’s future payout will be high, then the present discounted value of that asset’s payout will go up—i.e., will increase. If the asset’s current price doesn’t increase accordingly, any trader who sees the signal could profit by buying a share, :

   

In the process, the trader will push up the current price until there’s no longer any benefit to continuing the trade. And we’d see the opposite pattern with in a world where traders saw a negative signal.

Given this benchmark, behavioral economists look for situations where there appears to be a persistent uncorrected pricing error. e.g., under the benchmark of market efficiency, it should not be possible to find situations where without traders taking action, . However, JegadeeshTitman93 document that the 30% of stocks with the highest past returns (past winners) tend to have higher future returns than the 30% of stocks with the lowest past returns (past losers). In a world where markets were efficient, traders would immediately bid up the prices of past winners until this pricing error disappeared. So it seems like real-world traders must be making some sort of behavioral error.

Corporate finance

ModiglianiMiller58 taught us that, if all the following assumptions hold, then a firm’s choice of leverage has no affect on its market valuation. (A1) Investors and firms can trade the same set of correctly priced securities. (A2) Investors and firms are taxed in the same way. (A3) Investors and firms face no transaction costs or portfolio restrictions. (A4) There are no bankruptcy costs or costs to issuing new securities. (A5) A firm’s choice of leverage doesn’t directly affect its future cash flows. And finally, (A6) firm leverage doesn’t signal additional information to investors about these cash flows. Firms clearly spend a lot of time worrying about their capital structure. And corporate researchers explain their decisions by pointing out ways that the above assumptions are violated in the real world. That’s the organizing principle behind this literature.

The streamlined proof given in ModiglianiMiller69 is based on a homemade-leverage argument. Suppose there are two firms with different capital structures but identical cash flows. The first firm is unlevered while the second firm as issued debt. In a world where all the above assumptions hold, an investor could effectively lever up the unlevered firm’s cash flows himself by constructing a portfolio that’s long the unlevered firm and short the debt issued by the levered firm:

   

If there’s any gap between the cost of this portfolio and the equity value of the levered firm, an investor could earn arbitrage profits given the assumptions above. Since both have identical future cash flows, the investor should continue buying the one with the lower current price until there’s no more price difference.

“The entire development of corporate finance since 1958—the publication date of the first MM article—can be seen and described essentially as the sequential (or simultaneous) relaxation of the assumptions listed before.” e.g., if corporate debt is taxed differently than the short positions of individual investors, then the homemade-leverage argument breaks down. Once assumption A2 has been violated, capital structure is no longer irrelevant. In a world where corporations get preferred tax treatment, firms should optimally choose to issue debt since it’d be more expensive for individual investors to homebrew this leverage themselves.

Nobody would say…

Given how I’ve described behavioral finance and corporate finance above, it’s obvious that the two fields are organized in the exact same way. Researchers in each field try to make sense of empirical regularities by pointing to specific deviations from their own respective benchmark. In fact, Mark Rubinstein argues that ModiglianiMiller58’s “real and enduring contribution was to point others in the direction of arbitrage reasoning.” And this sort of reasoning lies at the heart of the Efficient Market Hypothesis in Fama70.

That being said, the behavioral-finance and corporate-finance literatures clearly emphasize different things about their respective benchmark models. ModiglianiMiller58 weren’t trying to argue that the assumptions needed for capital-structure irrelevancy were realistic. As Merton Miller later wrote: “We first had to convince people (including ourselves!) that there could be any conditions, even in a ‘frictionless’ world, where a firm would be indifferent between issuing different kinds of securities.”

By contrast, market efficiency is treated as a good first approximation to the real world. While Franco Modigliani and Merton Miller didn’t think that capital structure was actually irrelevant in the real world, Eugene Fama actively defended the Efficient Market Hypothesis. e.g., Fama98 writes: “There is a developing literature… arguing that stock prices adjust slowly to information… It is time, however, to ask whether this literature, viewed as a whole, suggests that efficiency should be discarded. My answer is a solid no.”

This is fine. But the parallel structures of behavioral finance and corporate finance clearly put the lie to a common criticism of the behavioral literature. It’s often argued that, to be a honest-to-goodness scientific discipline, the behavioral-finance literature needs to offer a single coherent alternative model to challenge the Efficient Market Hypothesis. e.g., later in Fama98, it’s claimed that behavioral economists “rarely test a specific alternative to market efficiency… This is unacceptable… Following the standard scientific rule, however, market efficiency can only be replaced by a better specific model of price formation.”

That is nonsense. It’s a criticism that applies equally well to the corporate-finance literature, which has not produced a better specific model than the one in ModiglianiMiller58. However, no one would claim that Jean Tirole’s textbook is unscientific. Overturning ModiglianiMiller58 isn’t the point of corporate-finance research. Overturning the Efficient Market Hypothesis isn’t the point of behavioral-finance research. In both cases, the point is to provide good explanations for how the real-world works. If progress is fastest when researchers organize their thinking relative to a benchmark model, then so be it.