aspiration levels. This paper investigates how reference points and aspiration impact the risk profiles of
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.
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,
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.
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.
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
See Köszegi and Rabin (2006) for a discussion about reference point formation, which is similar in spirit to March and
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.
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
CAI AND SHEFRIN