Chapter 1

Governance
ESG governance standards ensure a company uses accurate and
transparent accounting methods, pursues integrity and diversity in
selecting its leadership, and is accountable to shareholders.
ESG investors may require assurances that companies avoid conflicts
of interest in their choice of board members and senior executives,
don't use political contributions to obtain preferential treatment, or
engage in illegal conduct.
Conflict between ESG criteria and financial performance

Adopting ESG principles means that corporate strategy focuses on the

three pillars of the environment, social, and governance. This means
taking measures to lower pollution, CO2 output, and reduce waste. It
also means having a diverse and inclusive workforce, at the entry-level
and all the way up to the board of directors.
Achieving success in all three of the ESG criteria as well as achieving
good financial returns is a difficult balancing act, because an ESG focus
can be costly and time-consuming to undertake.
When making decisions on new projects and strategies, financial
managers have to make judgements on how to balance the competing
financial and ESG issues.
There is more detail later in this chapter on how financial managers
deal with conflicts when making decisions.

Behavioural finance

Introduction

Conventional financial management is based on the assumption that

markets are efficient, and that investors behave in ways that are logical
and rational.
The efficient market hypothesis (EMH)

The EMH states that security prices fully and fairly reflect all relevant
information. This means that it is not possible to consistently
outperform the market by using any information that the market already
knows, except through luck.
The idea is that new information is quickly and efficiently incorporated
into asset prices at any point in time, so that old information cannot be
used to predict future price movements.

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Behavioural finance

Despite the evidence in support of the efficient markets theory, some

events seem to contradict it, such as significant share price volatility
and boom/crash patterns e.g. the stock market crash of October 1987
where most stock exchanges crashed at the same time. It is virtually
impossible to explain the scale of those market falls by reference to any
news event at the time.
An explanation has been offered by the science of behavioural finance.
Behavioural finance is a relatively new field that seeks to combine
behavioural and cognitive psychological theory with conventional
economics and finance to provide explanations for why people make
irrational financial decisions.
Key concepts of behavioural finance

Pioneers in the field of behavioural finance have identified the following

factors as some of the key factors that contribute to irrational and
potentially detrimental financial decision making:
Anchoring – investors have a tendency to attach or 'anchor' their
thoughts to a reference point – even though it may have no logical
relevance to the decision at hand e.g. investors are often attracted to
buy shares whose price has fallen considerably because they compare
the current price to the previous high (but now irrelevant) price.
Gambler's fallacy – investors have a tendency to believe that the
probability of a future outcome changes because of the occurrence of
various past outcomes e.g. if the value of a share has risen for seven
consecutive days, some investors might sell the shares, believing that
the share price is more likely to fall on the next day. This is not
necessarily the case.
Herd behaviour – this is the tendency for individuals to mimic the
actions (rational or irrational) of a larger group. There are a couple of
reasons why herd behaviour happens. The first is the social pressure of
conformity – most people are very sociable and have a natural desire to
be accepted by a group. The second is the common rationale that it's
unlikely that such a large group could be wrong. This is especially
prevalent in situations in which an individual has very little experience.
Over-reaction and availability bias – according to the EMH, new
information should more or less be reflected instantly in a security's
price. For example, good news should raise a business' share price
accordingly. Reality, however, tends to contradict this theory. Often,
participants in the stock market predictably over-react to new
information, creating a larger-than-appropriate effect on a security's
price.

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Confirmation bias – it can be difficult to encounter something or

someone without having a preconceived opinion. This first impression
can be hard to shake because people also tend to selectively filter and
pay more attention to information that supports their opinions, while
ignoring or rationalising the rest. This type of selective thinking is often
referred to as the confirmation bias.
In investing, the confirmation bias suggests that an investor would be
more likely to look for information that supports his or her original idea
about an investment rather than seek out information that contradicts it.
As a result, this bias can often result in faulty decision making because
one-sided information tends to skew an investor's frame of reference,
leaving them with an incomplete picture of the situation.
Hindsight bias and overconfidence – hindsight bias occurs in
situations where a person believes (after the fact) that the onset of
some past event was predictable and completely obvious, whereas in
fact, the event could not have been reasonably predicted.
Many events seem obvious in hindsight. For example, many people
now claim that signs of the technology bubble of the late 1990s and
early 2000s were very obvious. This is a clear example of hindsight
bias: If the formation of a bubble had been obvious at the time, it
probably wouldn't have escalated and eventually burst.
For investors and other participants in the financial world, the hindsight
bias is a cause for one of the most potentially dangerous mind-sets that
an investor or trader can have: overconfidence. In this case,
overconfidence refers to investors' or traders' unfounded belief that they
possess superior stock-picking abilities.
Student Accountant article

The article 'Patterns of behaviour' in the Technical Articles section of

the ACCA website provides further details on behavioural finance.

Raising finance and minimising the cost of capital

A key aspect of financial management is the raising of funds to finance existing

and new investments. As with investment decisions, the main objective with
raising finance is assumed to be the maximisation of shareholder wealth.
The following issues thus need to be considered when setting criteria for future
finance and deciding policies:
 Is the firm at its optimal gearing level with associated minimum cost of
capital?
 What gearing level is required?
 What sources of finance are available?

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