Focal points and firm risk

• Published date: 01 September 2018
• DOI: http://doi.org/10.1111/eufm.12174
• Date: 01 September 2018
• Author: Ye Cai,Hersh Shefrin

DOI: 10.1111/eufm.12174

ORIGINAL ARTICLE

Focal points and firm risk

Ye Cai

|

Hersh Shefrin

Leavey School of Business, Santa Clara

University, Santa Clara, California

Emails: ycai@scu.edu; hshefrin@scu.edu

Abstract

The ‘better than average’effect suggests that relative

industry standing should serve as an important focal point

for corporate managers. March and Shapira (Psychological

Review,99, 172–183, 1992) develop a framework to

analyze the impact of focal points on firms’risk profiles.

This paper uses the March–Shapira model to investigate the

relationship between firms’relative industry standings and

their risk profiles. We find that firms’equity returns display

strong March–Shapira effects. When we examine the

different firm decisions that impact risk, we find the strong

presence of March–Shapira effects in firms’decisions about

operating cash flows, diversifying acquisition activity,

working capital, and capital structure.

KEYWORDS

aspiration, ‘better than average’effect, corporate risk-taking, focal

points

JEL CLASSIFICATION

G02, G34

1

|

INTRODUCTION

A key aspect of prospect theory (Kahneman & Tversky, 1979) is that decision-makers frame outcomes

as either gains or losses, and make choices about risk that strongly depend on how they perceive their

circumstances in respect to gains and losses relative to reference points. A key aspect of SP/A (security

potential/aspiration) theory (Lopes, 1987; Lopes & Oden, 1999) is that reference points reflect

We thank Jim March, Zur Shapira, and David Hirshleifer and acknowledge a special debt of gratitude to the editor Lu

Zhang and an anonymous referee whose comments led to significant improvements in the paper.

Eur Financ Manag. 2018;24:521–544. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

|

521

aspiration levels. This paper investigates how reference points and aspiration impact the risk profiles of

firms.

We rely on the March–Shapira model (March & Shapira, 1992) to analyze corporate risk-taking.

The March–Shapira model uses the term ‘focal point’in place of ‘reference point,’and postulates that

firms have two potential focal points, a lower one corresponding to survival and a higher one

corresponding to aspiration (upside potential). According to the theory, the combination of a firm's

current situation and a random component determines which focal point regime is more likely to be

operative. The theory suggests that for distressed firms, survival is more likely to be operative, and for

non-distressed firms, aspiration is more likely be operative.

Aspiration points demarcate the border between psychological success and failure. At the

individual level, firms are likely to vary in their precise aspiration points.

1

Rather than seeking to

identify firm-specific aspiration points, and how these vary over time, we instead adopt a simpler

approach. Our approach is to assume that firms define success by setting their aspiration levels at

median industry performance. With this assumption, success means being ‘better than average.’

Although this assumption might not apply to all firms, the psychology literature on overconfidence

provides strong evidence of aversion to feeling below average (e.g., McKenna, Stanier, & Lewis,

1991).

In the case of non-distressed firms, the model features two outcome regions, one below aspiration

(shortfall) and one at or above aspiration (surplus). According to the model, firms that find themselves

in circumstances that qualify as being below aspiration, and for whom aspiration is operative, take on

relatively high risk. However, as the shortfall shrinks, the amount of risk declines. When the shortfall

turns into a surplus, risk falls discontinuously at the juncture, but then increases with the magnitude of

the surplus. We call the associated aspiration response pattern ‘V-shaped,’with a gap where the two

sides of the V would join. According to March and Shapira (1992), the left side of the V is more steeply

sloped than the right side.

2

When survival is operative, risk increases the more distant the firm's

circumstances are from the survival point. Figure 1, which is taken from March and Shapira (1992),

summarizes the structure of the model.

3

Firms’managers make many types of decisions that impact the overall risk of their organizations.

They make operating decisions that impact volatility associated with cash flows from operations. They

make acquisition decisions about whether or not to engage in diversifying mergers. They make

decisions about liquidity and leverage that impact their credit risk, and the volatility of their equity. For

this reason, we investigate the degree to which these different decisions are similar, or not, when

viewed through the lens of the March–Shapira model.

Risk-seeking behavior occupies an important place in the corporate finance literature. According to

Myers (1977), debtholders of distressed firms featuring debt overhang will find it in their interest to

1

See Köszegi and Rabin (2006) for a discussion about reference point formation, which is similar in spirit to March and

Shapira (1992).

2

Ronay and von Hippel (2010) report that risk-taking is related both to testosterone levels and to power. They note that

although high testosterone levels are associated with the pursuit of power, those individuals who have achieved power are

inclined to be risk-avoidant, despite elevated testosterone levels. This finding is in line with the March–Shapira feature that

above-aspiration firms are more conservative in their risk profiles than below-aspiration firms.

3

March–Shapira is a dynamic model, in which firms set aspiration levels based on managers’expectations, and adjust their

aspirations over time in response to firm performance. In this respect, the model depicted in Figure 1 describes the firm's

circumstances by the value of its assets, and risk as the standard deviation of that value. By transforming the value

variables to returns, we effectively change the scale of measurement and, in doing so, are able to compare firms more

easily.

522

|

CAI AND SHEFRIN