Behavioral Finance: Capital Budgeting and Other Investment Decisions

This chapter surveys the literature on the effects of behavioral biases on capital budgeting. A large body of the psychology literature finds that people tend to be overconfident and overly optimistic. Because of self-selection, firm managers tend to be even more affected by these biases than the general population. Indeed, the literature finds that biased managers overinvest their firm’s free cash flows, initiate too many mergers, start more firms and more novel projects, and tend to stick with unprofitable investment policies longer. Corrective measures to reduce the effects of the managers’ biases include learning, inflated discount rates, and contractual incentives, but their effectiveness in curbing overinvestment appears to be limited. * This article will appear in Behavioral Finance, edited by H. Kent Baker and John R. Nofsinger, and published by Wiley/Blackwell.