Decision makers become risk-seeking both when they have enjoyed greater gains in the past and when they have suffered losses previously, albeit for different reasons. This study by Professor Jaya Dixit of the Indian School of Business and Professor M V S Kumar of the Lally School of Management & Technology, New York, shows that they become risk-seeking in the realm of prior gains because they code potential losses as reductions in the previous gains versus absolute losses. They become risk-seeking in the realm of prior losses when they see possibility of breaking even.
Acquisitions are significant investments by firms where the risks are said to derive due to reasons anywhere from incorrect valuation, to implementation. At the heart of these risks is the existence of uncertainty and information asymmetry (between target and the acquirer, between the stock market and the firms involved in the acquisition). These risks in acquisitions have been studied mostly through an economic lens. However, researchers have also shown that psychological or behavioural factors matter in acquisition decision making. For example a study by Mathew Hayward and Donald Hambrick shows that overconfident CEOs pay greater acquisition premium which leads to shareholder losses.
While the role of hubris in acquisitions is well established in the literature, evidence with regard to additional psychological and behavioural factors and their impact on acquisitions has been elusive and therefore difficult to demonstrate. This study focuses on providing evidence consistent with two influential theories of behavioural decision making: the Prospect Theory and the House Money Effect. Primarily we look at the effect of the stock market reaction to a prior acquisition by a firm on risk taking in a subsequent acquisition to highlight how decision makers behave consistent with these theories. Through this research we also seek to document how stock market reactions have a real impact on future decision making of managers.
House Money Effect and Prospect Theory
Building from experimental evidence, Prospect Theory and House Money Effect provide key insights, especially in terms of how decision makers react to outcomes from actions that are similar in the past. To illustrate the insights, consider a gambler in a casino playing on a roulette wheel that generates losses and gains. For hypothetical purposes, let us say the fi rst spin of the wheel resulted in a favourable outcome and the gambler made a gain on the bet. This sets up an interesting question- now having won, should the gambler take more risk on the next spin of the wheel?
Risks in acquisitions have been studied mostly through an economic lens. However, researchers have also shown that psychological or behavioural factors matter in acquisition decision making. For example a study shows that overconfident CEOs pay greater acquisition premium which leads to shareholder losses.
The answer of course is no. Insights from Subjective Expected Utility (SEU) theory of rational choice and decision making would tell us that all that matters is the probabilities of the final states and not how those states are reached. Hence, there should be no difference in risk taking the second time around for the gambler as s/he spins that roulette, after winning a hand previously, as long as the probability of winning stays the same. The key point of departure by behavioural theories of decision making is that reference points matter, and that decision makers are not necessarily indifferent between two alternatives which generate the same final wealth or asset positions, having already gained or lost previously. Put simply, behavioural theories suggest that our hypothetical gambler is indeed likely to take more risk (e.g. by betting more money) in the next spin, having won in the previous spin. Similarly, behavioural theories also suggest under certain circumstances our gambler may take more risk even after having lost in the prior spin, in an attempt to re-establish his/her reputation and/or break even.
Individuals who enjoy large gains, take greater risks subsequently. The reason is because gains travel in individuals’ mental accounts in such a way that any potential losses after gains, appear as reduction in gains rather than as absolute losses. This behaviour is akin to “gambling with the house money”. A gambler who has won a big hand recently would take greater risks because he/she frames a potential loss as a decrease, not in his final wealth position, but in the gains he acquired in the previous round.
More formally, Prospect Theory argues that managers become much more prone to risk-taking at the prospect of losses. As economists Daniel Kahneman and Amos Tversky, observe, “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” Here the prior loss acts as the reference point which becomes salient in managers’ calculations of prospects of current decision being successful or not. The larger the loss suffered, the more is the tendency to try and break even and hence the more risks these individuals undertake.
Paralleling these observations, Thaler and Johnson, show through their laboratory experiments how individuals who enjoy large gains, take greater risks subsequently. The reason is because gains travel in individuals’ mental accounts in such a way that any potential losses after gains, appear as reduction in gains rather than as absolute losses. They call this behaviour akin to “gambling with the house money”. A gambler who has won a big hand recently would take greater risks because he/she frames a potential loss as a decrease, not in his final wealth position, but in the gains he acquired in the previous round.
To summarise, researchers through laboratory experiments have shown that individuals become risk-seeking both when they have enjoyed greater gains in the past and when they have suffered losses previously, albeit for different reasons. They become risk-seeking in the realm of prior gains because they code potential losses as reductions in the previous gains versus absolute losses. They become risk-seeking in the realm of prior losses when they see possibility of breaking even. A caveat in the realm of losses is that decision-makers will become risk-averse in face of prior losses if their survival is threatened.
Psychological Factors and Risk-Taking in Acquisitions
The above experimental evidence provides key insights, which in this research we extend towards understanding risk-taking in acquisitions. In our setting, stock market reactions to prior acquisitions provide the reference point for future acquisition choices. Managers frame their potential losses and gains against this reference point which in turn leads to a systematic shift in their risk-taking if the stock market reacts positively to the prior acquisition, we posit that managers are likely to become risk seeking in the next acquisition, since potential losses will be judged by decision-makers as a reduction in previous gains. Hence, larger the gains in previous acquisition, the more risks acquirers take in the subsequent acquisition. Conversely, if the stock market reacts negatively, then we propose managers will become risk seeking in the next acquisition, as they seek to recover from their losses and re-establish their reputations as good deal-makers. Accordingly, larger the losses in previous acquisition, the more risks managers undertake. To test these propositions, this research looks at completed acquisition deals between 1990 and 2006 for public acquirers and targets in the US. We use standard event study methods to measure stock market reactions in absolute dollar terms. Risk in acquisition is measured as riskiness of the target acquired which is calculated as the stock volatility of the acquired target. We find that amongst firms that have suffered stock market losses, there is a significantly positive association between the magnitude of market losses in previous acquisition and the risks undertaken in the subsequent acquisition. This finding provides evidence consistent with the break-even effect where managers try to make up the losses previously incurred. Additionally, we find a positive association between the magnitude of stock market gains in previous acquisitions and risk undertaken in the subsequent acquisition. This evidence is consistent with house money effect where managers gauge risks by looking at potential losses, not absolutely, but in relation to reductions in the previously realised gain. Essentially, we find a V-shaped relationship between prior stock market acquisition performance and risk-taking in subsequent acquisition.
Researchers through laboratory experiments have shown that individuals become risk-seeking both when they have enjoyed greater gains in the past and when they have suffered losses previously, albeit for different reasons. They become risk-seeking in the realm of prior gains because they code potential losses as reductions in the previous gains versus absolute losses. They become risk-seeking in the realm of prior losses when they see possibility of breaking even.
Economic models of decision making suggest that risk-taking in a particular acquisition should the more risks acquirers take in the subsequent acquisition. Conversely, if the stock market reacts negatively, then we propose managers will become risk seeking in the next acquisition, as they seek to recover from their losses and re-establish their reputations as good deal-makers. Accordingly, larger the losses in previous acquisition, the more risks managers undertake.
To test these propositions, this research looks at completed acquisition deals between 1990 and 2006 for public acquirers and targets in the US. We use standard event study methods to measure stock market reactions in absolute dollar terms. Risk in acquisition is measured as riskiness of the target acquired which is calculated as the stock volatility of the acquired target.
We find that amongst firms that have suffered stock market losses, there is a significantly positive association between the magnitude of market losses in previous acquisition and the risks undertaken in the subsequent acquisition. This finding provides evidence consistent with the break-even effect where managers try to make up the losses previously incurred. Additionally, we find a positive association between the magnitude of stock market gains in previous acquisitions and risk undertaken in the subsequent acquisition. This evidence is consistent with house money effect where managers gauge risks by looking at potential losses, not absolutely, but in relation to reductions in the previously realised gain. Essentially, we find a V-shaped relationship between prior stock market acquisition performance and risk-taking in subsequent acquisition. Economic models of decision making suggest that risk-taking in a particular acquisition should solely depend on the synergies to be achieved in the acquisition. Hence on an average, there should be no observable relationship between prior stock market reactions to an acquisition and risk-taking in the following acquisition. While stock market reactions may inform decision making under certain circumstances, they should not be impacting the risk taking propensities of managers. In this research we observed how cognitive and psychological perspectives of decision making complements the economic models by showing how stock market performance in prior acquisitions systematically impacts risk-taking in subsequent acquisitions. A key implication of this research is that prior market reaction is an important reference point for managers in their acquisition decision.
Another implication of this study is that managers should be cautious in terms of how their decisions get influenced by stock market reactions. While prices and market reactions have information that is useful in decision making, given the behavioural factors at play, stock performance can also create risk-seeking tendencies.
Future Direction
This research is part of an ongoing agenda to try and understand how prior stock market reactions impact subsequent acquisition decisions. As such, we are now looking at factors that mitigate and strengthen the base relationships we have discovered in this study. Additionally, we are investigating what other aspects of acquisition decisions are impacted due to the behavioural factors discussed, for e.g., bid premium, value of acquired assets compared to those of acquirers, etc.
Note: This study has been published in Strategic Management Journal. The citation for the study is M V S Kumar, J Dixit & B Francis (2015). The impact of prior stock market reactions on risk taking in acquisitions. Strategic Management Journal. doi: 10.1002/smj.2349