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Brief Contents
Preface to the Second Edition   xv
Acknowledgments  xix

1 Behavioral Foundations  1
2 Introduction to Behavioral Analysis 32
3 Valuation  58
4 Capital Budgeting  85
5 Inefficient Markets and Corporate Decisions   110
6 Perceptions about Risk and Return   131
7 Capital Structure  149
8 Dividend Policy  180
9 Agency Conflicts and Corporate
Governance  200
10 Mergers and Acquisitions   227
11 Financial Management and Group Process   257
12 Application of Real-Option Techniques to Capital Budgeting
and Capital Structure (only available at
www.mhhe.com/shefrin2e)  270
13 Behavioral Aspects of Investments (only available at
www.mhhe.com/shefrin2e) 271

GLOSSARY  272
ENDNOTES  275
INDEX  294

vii
Table of Contents
Preface to the Second Edition xv Chapter 2
Acknowledgments xix Introduction to Behavioral Analysis 32
2.1 Traditional Treatment of Corporate
Financial Decisions 32
Chapter 1 2.2 Behavioral Treatment of Corporate
Behavioral Foundations 1 Financial Decisions 33
2.3 Analyzing Biases 35
1.1 Traditional Corporate Financial Decisions Excessive Optimism 36
and Psychological Tasks 1 Overconfidence 38
Dual Systems 3 Confirmation Bias 40
1.2 Biases 4 Illusion of Control 40
Excessive Optimism 4 2.4 Analyzing Heuristics 41
Overconfidence 6 Representativeness 41
Confirmation Bias 8 Availability 41
Illusion of Control 9 Anchoring and Adjustment 42
1.3 Heuristics 11 Affect Heuristic 42
Representativeness 11 2.5 Value Destruction and Sun’s Endgame 43
Availability 12 2.6 Analyzing Framing Effects 44
Anchoring and Adjustment 13 Loss Aversion 46
Affect Heuristic 14 Aversion to a Sure Loss 48
Interacting Phenomena 15 Lawsuits and Aftermath 49
1.4 Framing Effects 16 2.7 Debiasing and Nudges 51
Loss Aversion 16 Summary 52
The Fourfold Risk Pattern 17 Additional Behavioral Readings 53
Framing Pitfalls 19 Key Terms 53
Prospect Theory 21 Explore the Web 53
Aspiration Points 22 Chapter Questions 53
1.5 Mitigating Pitfalls 23 Additional Resources and Materials for Chapter 2
Summary 25 Are Available at www.mhhe.com/shefrin2e 55
Additional ­Behavioral Readings 26 Minicase: Nuclear Meltdown at Fukushima
Key Terms 26 Daiichi 55
Explore the Web 27 Case Analysis Questions 57
Chapter ­Questions 27 A2.1 Minicase: Hurricanes and Psychology:
Additional Resources and Materials for From Wall Street of the Southwest to the
Chapter 1 Are Available at www.mhhe.com Big Easy A2-1
/shefrin2e 30 Case Analysis Questions A2-4
Minicase: Panama Canal 30 Chapter 3
Case Analysis Questions 31
Valuation 58
A1.1 Questionnaire A1-1
A1.2 Representativeness and Bayes’ Rule A1-8 3.1 Traditional Approach to Valuation 58
A1.3 Formal Structure of Prospect Theory A1-10 3.2 Target Price Heuristics 59
viii
 Table of Contents ix

P∕E Heuristic 60 Chapter 4

PEG Heuristic 60 Capital Budgeting 85
Price-to-Sales Heuristic 60
3.3 A CFO’s Reliance on Valuation 4.1 Traditional Treatment of Capital Budgeting 85
Heuristics 61 4.2 
The Planning Fallacy 86
3.4 How Analysts Value Firms: An Illustrative The Planning Fallacy in Aircraft
Example 61 Manufacturing 87
Analyst Mary Meeker 61 4.3 Excessive Optimism and Overconfidence
The Morgan Stanley Team’s Mid-2004 in Capital Budgeting 88
Price Target for eBay 62 Excessive Optimism in Public-Sector
3.5 Valuation Heuristics and Biases: Projects 88
in Foresight 66 Excessive Optimism in Private-Sector
Optimism Bias: In Foresight 66 Projects 89
Biases Associated with P∕E, PEG, and PVGO: Agency Conflict Determinants of Excessive
In Foresight 69 Optimism 91
Biases Related to the 1∕n Heuristic: In Overconfidence 92
Foresight 71 Psychological Determinants of Excessive
Biases Using the CAPM Heuristic: In ­Optimism and Overconfidence 92
Foresight 72 4.4 Project Adoption Criteria 95
3.6 Valuation Heuristics and Biases: In The Importance of Intuition 96
Hindsight 72 The Affect Heuristic 97
3.7 Biases Associated with Free Cash Flow Choice, Value, and the Affect Heuristic 97
Formula 75 4.5 Reluctance to Terminate Losing projects 99
38. Agency Conflicts 77 Aversion to a Sure Loss 99
Summary 77 Escalation of Commitment 101
Additional ­Behavioral Readings 78 4.6 Confirmation Bias and Sunk Costs:
Key Terms 78 Illustrative Example 102
Explore the Web 78 Behavioral Bias and Agency Conflicts at
Chapter ­Questions 79 Syntex 103
Additional Resources and Materials for Summary 105
Chapter 3 Are Available at www.mhhe.com Additional Behavioral Readings 105
/shefrin2e 81 Key Terms 106
Minicase: Aetna 81 Explore the Web 106
Case Analysis Questions 84 Chapter Questions 106
A3.1 Definition and Derivation of Free Additional Resources and Materials for Chapter 4
Cash Flow A3-1 Are Available at www.mhhe.com/shefrin2e 107
A3.2 Growth Opportunity Bias Minicase: MGM Resorts International: Las
(GOB) A3-3 Vegas CityCenter 107
A3.3 Biases Associated with the Textbook Free Cash Case Analysis Questions 109
Flow Formula A3-6 A4.1 Detailed Description of Airbus’s A380
A3.4 Detailed Chronology of eBay, and Boeing’s 787 A4-1
2003–2014 A3-9 A4.2 Using Forecasts Prepared by Others A4-4
A3.5 Minicase: Palm Inc. A3-11 Implications A4-6
Case Analysis Questions A3-12 A4.3 Cost Accounting A4-6
x Table of Contents

The Framing of Costs A4-7 Detailed Look 137

Heuristics A4-7 6.4 Executives, Insider Trading, and Gambler’s
A4.4 Minicase: Compusys A4-10 Fallacy 140
Case Analysis Questions A4-12 6.5 Biases in Financial Executives’ Judgments
Relating to Risk, Return, and Discount
Chapter 5 Rates 141
Inefficient Markets and Corporate Discount Rate and WACC 142
Decisions 110 Summary 143
Additional Behavioral Readings 144
5.1 Traditional Approach to Market Efficiency 110 Key Terms 144
5.2 Behavioral Approach to Market Efficiency 111 Explore the Web 144
Irrational Exuberance and Stocks as a Whole 112 Chapter ­Questions 144
Sentiment Beta 112 Minicase: Elon Musk, Tesla Motors, Risk,
Limits to Arbitrage 113 and Return 145
Risk and Sentiment 114 Case Analysis Questions 148
Managerial Decisions: Market Timing and
Catering 114
5.3 Market Efficiency, Earnings Guidance, Chapter 7
and NPV 115 Capital Structure 149
5.4 Stock Splits 116
Example: Tandy’s Stock Split 117
7.1 Traditional Approach to Capital
5.5 To IPO or Not to IPO? 118 Structure 149
Three Phenomena 118
7.2 Behavioral Considerations Pertaining
IPO Decisions 119
to Financing and Investment 151
Summary 126 7.3 How Do Managers Make Choices About
Additional Behavioral Readings 126 Capital Structure in Practice? 153
Key Terms 126 New Equity: Market Timing 154
Explore the Web 126 New Debt: Financial Flexibility and Debt
Chapter Questions 127 Timing 155
Minicase: The IPOs of Groupon, Facebook, Target Debt-to-Equity Ratio 155
and Twitter 128 Traditional Pecking Order 157
Case Analysis Questions 130 7.4. Market Timing: How Successful? 157
Perception of Overvalued Equity: New
Chapter 6 Issues 158
Perception of Undervalued Equity:
Perceptions about Risk and Return 131
Repurchases 159
6.1 Traditional Treatment of Risk and Return 131 Debt Market Timing 160
6.2 Psychological Issues Estimating 7.5 Financial Flexibility and Project Hurdle
the Market Risk Premium 133 Rates 161
Die-Rolling 134 Undervalued Equity: Cash-Poor Firms Reject
Extrapolation Bias: The Hot-Hand Fallacy 135 Some Positive NPV Projects 161
Gambler’s Fallacy 136 Undervalued Equity for Cash-Limited Firms:
6.3 Biases in Financial Executives’ Judgments Invest or Repurchase? 161
of Market Risk Premium 136 7.6 Sensitivity of Investment to
Overview 137 Cash Flow 163
 Table of Contents xi

7.7 Psychological Phenomena and A8.1 Minicase: Nipsco A8-1

Interdependencies among Financing, Case Analysis Questions A8-1
Investment, and Cash 165
Excessive Optimism, Overconfidence, Chapter 9
and Cash 167 Agency Conflicts and Corporate
Identifying Excessively Optimistic, Overconfident Governance 200
Executives 168
Assessing Value 169 9.1 Traditional Approach to Agency Conflicts 200
7.8 Catering and the Conflict Between Short-Term 9.2 Paying for Performance in Practice 201
and Long-Term Horizons 171 Low Variability 202
Summary 172 Dismissal 202
Additional Behavioral Readings 173 Stock Options 202
Key Terms 173 Shareholder Rights 203
Explore the Web 173 9.3 Psychological Phenomena 204
Chapter Questions 173 From the Mouth of Directors 204
Minicase: Cogent Communications Prospect Theory and Stock Option-Based
and PSINet 176 Compensation 204
Case Analysis Questions 177 Risk Aversion and Impatience 206
Relative Incomes 209
Chapter 8 9.4 Incentives, Accounting, Auditing, and
Psychology 209
Dividend Policy 180
Earnings Management 210
8.1   Traditional Approach to Payouts 180 Auditing 210
8.2  Dividends and Investors: Psychology 181 9.5 Sarbanes-Oxley and COSO 212
Dividends and Risk: Bird in the Hand 181 Sarbanes-Oxley (SOX) 212
Self-Control and Behavioral Life Cycle H
­ ypothesis: COSO 213
Widows and Orphans 182 9.6 Fraud and Stock Options: Illustrative
Institutional Investors 184 Example 213
8.3 Survey Data Describing How Managers Signs of Disease? 216
Think about Dividends 185 9.7 Ethics and Cheating 217
Changing Payout Policies: Some History 185 Why Students Cheat 219
Survey Evidence 186 Ethics and Psychology: Why People Cheat 219
8.4 Dividend Policy and Investors’ Tastes 189 Summary 222
Citizens Utilities Company 189 Additional Behavioral Readings 222
Catering and Price Effects 190 Key Terms 223
Behavioral Signaling 191 Explore the Web 223
Summary 193 Chapter Questions 223
Additional ­Behavioral Readings 194 Additional Resources and Materials for Chapter 9
Key Terms 194 Are available at www.mhhe.com/shefrin2e 225
Explore the Web 194 Minicase: Hertz 225
Chapter Questions 195 Case Analysis Questions 226
Additional Resources and Materials for Chapter 8 From the Mouths of Board Members: Direct
A9.1 
Are Available at www.mhhe.com/shefrin2e 196 Quotations A9-1
Minicase: Apple 196 A9.2 Minicase: Tyco A9-1
Case Analysis Questions 198 Case Analysis Questions A9-2
xii Table of Contents

Chapter 10 A10.2 Two Monty Hall Problems A10-6

Mergers and Acquisitions 227 A10.3 Illustrative Example: Cisco Systems A10-8
Cerent Corporation A10-10
10.1 Traditional Approach to M&A 227 A10.4 Illustrative Example: AT&T A10-13
10.2 The Winner’s Curse 228 A10.5 Illustrative Example: 3Com and
Optimism, Overconfidence, and Other
10.3  U.S. Robotics A10-14
­Psychological Phenomena Impacting Risks and Benefits A10-14
­Acquiring ­Executives 228 Outcome A10-15
Psychological Drivers of Risk in M&A 231 A10.6 Illustrative Example: PSA Peugeot Citroen SA
Reference Point-Based Heuristic Effects and Daimler Chrysler AG A10-16
on Deal Negotiations 232 Additional Questions A10-17
10.4 Theory 233
Symmetric Information, Rational Managers, Chapter 11
and Efficient Prices 233
Financial Management and Group
Excessive Optimism and Overconfidence
When Prices Are Efficient 234
Process 257
Inefficient Prices, the Acquisition Premium, 11.1 Traditional Approach to Financial
and Catering 235 Management 257
Asymmetric Information and the Winner’s Curse 237 11.2 Process Loss 258
10.5 AOL Time Warner: The Danger of Trusting 11.3 General Reasons for Group Errors 259
Market Prices 238 Groupthink 259
Strategy and Synergy 238 Poor Information Sharing 260
Valuation 238 Inadequate Motivation 262
Asset Writedown 240 11.4 The Global Financial Crisis: Experiences
Hubris 242 of Different Firms 262
Aftermath 242 Financial Instability Hypothesis 263
10.6 Hewlett-Packard and Compaq Computer: Problematic Group Process and Psychological
Board Decisions 243 Phenomena at Financial Firms 264
The Merger Alternative 243 Summary 266
Psychological Basis for the Decision to Acquire Additional Behavioral Readings 267
Compaq 244 Key Terms 267
Valuation 244 Explore the Web 267
HP’s Board Accepts Reality 246 Chapter Questions 267
Aftermath 247 Additional Resources and Materials for
Summary 248 Chapter 11 Are Available at www.mhhe.com
Additional Behavioral Readings 249 /shefrin2e 268
Key Terms 249 Minicase: Toshiba 268
Explore the Web 249 Case Analysis Questions 269
Chapter Questions 249 A11.1 Enron and Worldcom A11-1
Additional Resources and Materials for Chapter 10 Enron A11-1
Are Available at www.mhhe.com/shefrin2e 251 Imagine Yourself in the Boardroom A11-4
Minicase: Yahoo! 251 WorldCom A11-4
Case Analysis Questions 255 A11.2 Decision Making at PSINet A11-5
A10.1 Avoiding the Winner’s Curse A10-1 A11.3 Behavioral Aspects of Fairness A11-6
Analytical Solution A10-1 Fairness and Confidence A11-9
 Table of Contents xiii
A11.4 Systemic Change: Process, Culture,
and ­Neuromanagement A11-10
Open Book Management A11-10
Neuromanagement and OBM A11-13
A11.5 Seagate: Extended Minicase A11-14
Case Analysis Questions A11-16
Chapter 12
Application of Real-Option Techniques to
Capital Budgeting and Capital Structure 270
The remaining contents of this chapter
are available at www.mhhe.com/shefrin2e 270
Chapter 12
Application of Real-Option Techniques
to Capital Budgeting and Capital
Structure A12-1
12.1 Traditional Approach to Option Theory A12-1
12.2 Do Managers Use Real-Option
Techniques? A12-2
Opaque Framing? A12-3
More Than a Decade Later: Have Viewpoints
Changed? A12-6
12.3 Valuing Levered Equity A12-6
Example A12-6
12.4 Conflicts of Interest A12-10
Example: Small-Scale Project A12-10
Asset Substitution A12-11
Debt Overhang A12-11
Capital Structure A12-12
12.5 Overconfidence and Excessive
Optimism A12-13
Overconfidence A12-13
Excessive Optimism A12-14
Capital Structure A12-18
Summary A12-19
Additional Behavioral Readings A12-19
Key Terms A12-20
Explore the Web A12-20
Chapter Questions A12-20
Minicase: The Savings and Loan Crisis
of the 1980s A12-21
Case Analysis Question A12-22
Chapter 13
Behavioral Aspects of Investments 271
The remaining contents of this chapter
are available at www.mhhe.com/shefrin2e 271
Chapter 13
Behavioral Aspects of Investments A13-1
13.1 Traditional Approach to Investments A13-1
13.2 Psychology and Market Efficiency A13-3
Anomalies and Pricing Factors A13-3
Long-Term Reversals: Winner–Loser
Effect A13-5
Momentum: Short-Term Continuation A13-5
Post-Earnings-Announcement Drift A13-6
Fixed Income Securities: The Expectations
Hypothesis A13-7
Options: Implied Volatility Function A13-7
13.3 Limits of Arbitrage A13-8
Pick-a-Number Game A13-9
13.4 Closed-End Funds A13-10
13.5 The Baker-Wurgler Sentiment Index A13-11
13.6 Risk and Return: Susceptibility to
Representativeness and the Affect
Heuristic A13-12
Example A13-13
Risk, Affect, Representativeness,
and Bias A13-13
Categorization A13-17
13.7 Sell-Side Analysts’ Judgments of Expected
Return A13-17
13.8 Active and Passive Investing A13-18
13.9 Forecasting Market Returns and Risk
Premiums A13-20
Individual Investors and the Hot-Hand
Fallacy A13-21
Professional Forecasters and Gambler’s
­Fallacy A13-22
Market Forecasts Made by Portfolio Managers
and Analysts A13-24
13.10 Realizing Gains and Losses: The Disposition
Effect A13-25
Psychological Phenomena Underlying the
Disposition Effect A13-25
Disposition Behavior A13-26
xiv Table of Contents

Valuation: The Endowment Effect and 13.16 Retirement Saving A13-45

Responsibility A13-28 13.17 Financial Planners A13-48
Momentum and the Disposition Effect A13-29 Financial Literacy A13-48
13.11 Individual Investors’ Stock Trades: Big Five A13-49
Overconfidence A13-30 Nudging Investors A13-51
13.12 Attention and Familiarity A13-31 13.18 Investment Committees A13-52
13.13 Fundamental Analysis and Technical Homogeneity A13-52
Analysis A13-33 Size A13-53
13.14 Behavioral Portfolio Selection Confirmation Bias A13-53
Framework A13-35 Overconfidence A13-53
Downside Protection and Upside Summary A13-53
Potential A13-35 Additional Behavioral Readings A13-54
Value Expressiveness and Socially Responsible Key Terms A13-54
Investing A13-37 Explore the Web A13-55
Diversification and Efficient Portfolios A13-38 Chapter Questions A13-55
13.15 Dividends, Self-Control, and Minicase: Two Foundations: Hewlett
Consumption A13-41 and Packard A13-59
Dividends and Frame Transparency A13-41 Case Analysis Questions A13-61
Mental Accounting-Based Spending Rules A13-43
Dividend Clienteles A13-44 Glossary 272
Price Changes, Returns, Framing, Endnotes 275
and Salience A13-45 Index 294
Preface to the Second Edition
GOALS AND STRUCTURE
The second edition of Behavioral Corporate Finance comes a decade after the pub-
lication of the first edition, which was the first textbook dedicated to providing
instructors with a comprehensive pedagogical approach for teaching students how
behavioral concepts apply to corporate finance. This second edition contains a great
deal of new material, as the academic literature in behavioral corporate finance
a decade ago was nascent. Notably, in the last 10 years this literature has mush-
roomed, and so the second edition has much upon which to draw.
Feedback from adopters of the first edition provides testimony to the fact that the
examples and cases in the first edition are unique in bringing behavioral corporate
finance alive. This is especially true of the minicases that conclude each chapter of
the first edition. The second edition contains a completely new set of minicases.
However, almost all of the minicases used in the first edition are still available in the
Additional Resources (available online) that accompany each chapter.
The goals and structure of the second edition are the same as in the first edition. The
primary goal is to identify the key psychological obstacles to value maximizing behav-
ior, along with steps that managers can take to mitigate the effects of these obstacles.
In this respect, instructors should view this book as a complement to traditional texts in
corporate finance, not as a substitute. Notably, neither students nor instructors require
a background in psychology to understand the key psychological concepts. All the key
concepts can be grasped intuitively, and are easily related to financial decisions.
The second edition can be viewed as something of an out-of-sample test. Most of the
examples and cases identified psychological phenomena in specific companies. The
second edition provides an opportunity to trace the implications of those phenomena
over the subsequent decade. Readers can judge for themselves whether the rest of those
stories were random outcomes, or instead natural outcomes of the underlying psycho-
logical phenomena being present. The same remark applies to the book Ending the
Management Illusion, which is a companion treatment to the first edition and analyzes
a completely different set of companies. Readers can judge for themselves whether,
after the publication of the book, the companies identified as being psychologically
smart went on to become successful and whether those that were identified as being
psychologically challenged went on to exhibit poor performance, if not outright failure.
Based upon advice from reviewers, the second edition features two new chap-
ters, and some rearrangement of chapter order from the first edition. The first new
chapter, Chapter 1, introduces the psychological foundations in depth. As a result,
instructors no longer need to rely on online Additional Resources for this material.
The second new chapter is Chapter 13, on investments. This chapter extends the
discussion from the application of behavioral concepts to corporate finance alone
to their application to investments. As a result, the book can be used to teach dedi-
cated courses in behavioral finance, not just corporate finance. To this end, instructors
can use the book to teach behavioral finance in much the same order that they teach

xv
xvi Preface to the Second Edition

t­ raditional finance: corporate finance first, followed by investments. At the same time,
the book has a modular structure, and therefore can be used as a secondary text in
regular investment courses as well as regular corporate finance courses. In this regard,
Chapter 1, which provides the behavioral foundations, Chapter 3 on valuation, and
Chapter 5 on market efficiency apply to investments as well to corporate finance.
As was mentioned in the Preface to the first edition, many traditional finance
textbooks, in both corporate finance and investments, have added behavioral chap-
ters. These additions serve as testimonials to the importance of behavioral ideas for
finance. At the same time, there is a limit to how much can be accomplished within
the confines of a single chapter, especially when it comes to integrating behavioral
concepts into the treatment of traditional topics. Coverage of behavioral issues in
traditional texts through a single-chapter approach has tended to be at best surface
level, providing students with a behavioral flavor but not with the in-depth skills
required to understand, identify, and deal with behavioral phenomena.
Teaching behavioral corporate finance is much more effective when the primary
focus is a specific topic such as capital budgeting or capital structure, and the discus-
sion focuses on the psychological dimension of the topic in question. In contrast, plac-
ing primary focus on psychological phenomena rather than specific corporate finance
topics shifts attention away from integration. A similar remark applies to investments.
For example, lumping technical analysis and behavioral finance into a single chapter,
as some authors do, is not only misleading but also takes focus away from the very
significant behavioral dimension in almost all other aspects of investment. This book
provides instructors in mainstream finance courses with a resource that will allow
them to identify the behavioral dimension in each topic they teach, and offer their
students an integrated approach that combines traditional and behavioral perspectives.

ORGANIZATIONAL DESIGN
This book identifies the key behavioral concepts associated with every major topic
in corporate finance: capital budgeting, capital structure, valuation, dividend policy,
corporate governance, and mergers and acquisitions. However, the book provides
only a brief summary of the traditional approach to each topic, whose purpose is to
provide context. Instructors are assumed to teach the traditional approach from the
traditional textbook of their choice. Instructors who use this book as a behavioral
supplement in a traditional finance course can cover topics in the traditional man-
ner, and then follow up the discussion by introducing the behavioral dimension.
Instructors who use this book to teach a behavioral finance course can build on prior
finance courses, and briefly summarize the traditional approach before introducing
the behavioral approach to each topic. Questions and minicases appearing at the end
of the chapters are designed to help students recognize the strength, magnitude, and
persistence of behavioral phenomena in financial decision making.
Chapter 11 broadens the discussion of Chapter 9 from the first edition and makes
the point that financial management means more than corporate finance. Rather,
financial management entails the integration of corporate finance and management,
meaning the incorporation of the psychological dimension into corporate financial
decision making. Failures in financial management, especially risk management,
 Preface to the Second Edition xvii

lie at the heart of the global financial crisis. Examples from the financial crisis il-
lustrate the main ideas in the chapter.
With a few exceptions, each chapter is devoted to a traditional topic. The excep-
tions are Chapters 1, 2, 11, and 13. Chapters 1 and 2 introduce the key psychological
concepts used throughout the book. Chapter 1 provides a detailed presentation of 10
important psychological concepts, with the emphasis on psychology, not finance.
Chapter 2 is devoted to explaining how these concepts apply to finance, and it is a
prerequisite for every subsequent chapter. Every other chapter explains how con-
cepts developed in Chapters 1 and 2 apply to traditional topics in corporate finance
and to investments. Notably, Chapter 2 has been written to be self-contained, and so
those wishing to proceed directly to the application of the the 10 key psychological
concepts can do so without working first through Chapter 1.
For example, Chapter 1 introduces students to the concept of excessive ­optimism,
and Chapter 2 describes how it impacted the decisions of the CEO of a specific
firm. Chapter 3 then describes how excessive optimism affects valuation. Chapter 4­
describes how excessive optimism affects capital budgeting. Chapter 7 describes
how excessive optimism affects capital structure. The main issue is not to be repeti-
tive about the fact that corporate managers tend to be excessively optimistic. The
main issue is to explain how excessive optimism impacts the different decisions that
managers are called upon to make.
Chapter 11 is entitled Financial Management and Group Process, and does not
have an obvious counterpart in traditional textbooks on corporate finance. This
chapter makes the point that financial management involves more than just corporate
finance, but instead entails the integration of corporate finance and management.
Chapters follow a set format. Behavioral objectives for learning introduce each
chapter. Most chapters have a section that provides a brief overview of the tradi-
tional approach to the topic at hand. The remainder of the chapter then focuses on
developing the behavioral concepts and applications.
In order to help students focus on the underlying psychological issues, “Con-
cept Preview Questions” are used. These are intended to help students reflect on
how their own minds approach information and decision tasks. Thematic boxes,
labeled “Behavioral Pitfalls” provide brief illustrations of business situations that
feature the psychological phenomena being discussed. Hints for mitigating bias and
error are provided in thematic boxes labeled “Corporate Nudges,” or in the case of
Chapter 13 “Investor Nudges.”
Chapter summaries review the main points of the chapter in relation to the learn-
ing objectives. Chapter questions provide focused exercises to help students learn
the key points in the chapter. Every chapter concludes with a minicase, allowing stu-
dents the opportunity to develop the skills of recognizing psychological phenomena
within the context of real world events.
The behavioral objectives, concept preview questions, thematic boxes and chapter
summaries contain the major points in the book. Illustrative examples, anecdotes and
cases serve as the most effective way of communicating general findings and ideas.
Most students relate easily to stories. However, the stories are only intended to com-
municate the main points. The general evidence is based on the academic studies
described in the book.
xviii Preface to the Second Edition

As was mentioned above, Chapters 1 and 2 are prerequisites to all the remaining
chapters. However, all remaining chapters essentially stand alone, so that instruc-
tors have the flexibility to choose whichever chapters they deem appropriate, and in
whatever order they find most useful.

INTENDED MARKET: CORPORATE FINANCE COURSES

I have written Behavioral Corporate Finance for use in any course devoted to teach-
ing either corporate finance or behavioral finance. For traditional courses in corpo-
rate finance, I see the book being used as a supplement to any traditional textbook
that serves as the primary course text. This pairing of a traditional primary corporate
finance text and Behavioral Corporate Finance provides a powerful way to augment
the teaching of traditional skills with an understanding of the psychological factors
that influence the application of these skills in practice. In this respect, Behavioral
Corporate Finance contains many real-world examples and case studies, designed to
bring the behavioral concepts to life. Similar remarks apply to courses in Investment,
which can draw on Chapter 13.
Behavioral pitfalls represent one of the most important obstacles to the suc­cessful
implementation of the skills taught in traditional corporate finance courses. When
it comes to improving the financial decision process, understanding these pitfalls
is a­ bsolutely essential. Therefore, a crucial challenge is to teach students nudging
techniques for avoiding psychological pitfalls identified in the behavioral decision
literature, as well as how to deal with others that do fall into the associated traps.

INSTRUCTOR RESOURCES
All of the instructor resources for this text are available on the book web site at
www.mhhe.com/shefrin2e. We put them in one place for easier access and
convenience.
• The Instructor’s Manual includes a chapter overview, learning objectives, key
terms, and presentation of the material which organizes the material around the
PowerPoint Presentation. Solutions to the end of chapter questions and mini-
cases are also provided.
• PowerPoint Presentation Slides contain key points and summaries to help in-
structors give lectures on the main ideas in the chapter.
• Test Bank, prepared by David Distad of the University of California, Berkeley,
contains a variety of true/false questions, multiple choice, and essay questions.
Complete answers are provided for all test questions and ­problems.
• Additional Minicases and Case Analysis Questions for selected chapters are
referenced in the text and available online.
For those interested in using Behavioral Corporate Finance as a text in a course
dedicated to behavioral finance, additional teaching resources are also provided on
the book web site. These resources expand the material presented in most chapters
and have been referenced in the text. In addition, separate chapters dealing with real
options and investments are also available on the web.
Acknowledgments
In the course of writing this book I benefited from discussions with managers, aca-
demics, consultants, and students. I learned a great deal from my fellow members
of the Santa Clara Valley chapter of Financial Executives International. I especially
thank those who gave guest lectures to my classes about how they practice corpo-
rate finance in their firms. Their insights were invaluable. My biggest debt is to the
students I taught in Santa Clara University’s executive MBA program, and to my
wife Arna. My executive MBA students all had at least 10 years of management
experience. By teaching them both traditional and behavioral corporate finance,
I learned how to structure the approach in the book. Among the individuals to
whom I would like to express appreciation are: Martha Amram, ­Herzel Ashkenazi,
Blair Baker, Eric Benhamou, Brigida Bergkamp, Ray Bingham, Bill Black, Tony
­Blagrove, David Bostwick, Alon Brav, Judy Bruner, Marshall Burak, Larry Carter,
Kris ­Chellam, Jeff Clarke, Tom Cupples, Greg Davies, George Davis, Patricia
Dechow, Robert Dunham, Jeremy DeGroot, Rajiv Dutta, Denise Esguerra-Aguilar,
Rami Fernandez, Jennifer Fromm, Diane Gale, Ken G ­ oldman, John Graham, Artie
Green, Robyn Greenwood, Sal Gutierrez, ­Campbell Harvey, Dirk Hackbarth, John
Heywood, David Hirshleifer, Mike Hope, Kuno Huisman, Mark Keil, Marc Kramer,
Mira Ma, Fred Kurland, Bruce Lange, Eddie Le, Sonia Li, Tim Loughran, Ulrike
Malmendier, Greg Matz, Webb ­McKinney, Laura McLeod, Manoj Mittal, Chris
Paisley, Bill Palmer, ­Phuong Quach, John Payne, William Pitney, Alex Potts, Betsy
­Raphael, George Reyes, Eduardo Repetto, Brian Reynolds, Jay Ritter, Chris Robell,
Mark Rubash, Christine .Russell, Stephen Schaefer, Claire Silverman, Gurkirpal
Singh, Bryce Skaff, Paul Slovic, Scott Smart, Song Ma, Meir Statman, Tom Stein, Don
Taylor, Ed Teach, Frans Tempelaar, Alex Triantis, Paul Tufano, George Vera, R ­ obert
Wayman, Ben Walker, KipWitter, Arnold Wood, Jeffrey Wurgler, and David Young.
I am indebted to the following people for their insightful reviews of the proposal
and various drafts of Behavioral Corporate Finance and their suggestions in the
preparation of the 1st and 2nd editions.

Paul Adams, David Distad,

University of Cincinnati University of California, Berkeley
Malcolm Baker, Robert Duvic,
Harvard Business School University of Texas at Austin
Candy Bianco, Christophe Faugere,
Bentley College State University of New York, Albany
Kirt Butler, Joseph J. French
Michigan State University University of Northern Colorado
Joseph Chen, University of Maryland
University of Southern California Gordon Hanka
Werner DeBondt, Vanderbilt University
DePaul University
xix
xx Acknowledgments

Hugh Hunter, Raghavendra Rau,

San Diego State University Cambridge University
Nancy Jay, Thomas Rietz,
Mercer University University of Iowa
D. Scott Lee, Robert Ritchey,
Texas A&M University Texas Tech University
David Lins, Scott Smart,
University of Illinois, Indiana University
Urbana-Champaign Richard Taffler,
Tim Manuel, Warwick University, UK
University of Montana Bijesh Tolia,
Joe Messina, Chicago State University
San Francisco State University P.V. Viswanath,
Shabnam Mousavi Pace University
Johns Hopkins University John Wald,
Roni Michaely, Rutgers University
Cornell University Arthur Wilson
Terrance Odean, George Washington University
University of California, Berkeley
Dilip Patro,
Rutgers University

In connection with this second edition, I want to thank Charles Synovec,

Executive Brand Manager; Noelle Bathurst, Senior Product Developer; and Tara
Slagle, Senior Content Project Manager. In connection with the first edition, I want to
acknowledge the direction and coaching by Chuck Synovec, Noelle Bathurst, Julie
Wolfe, Melissa Leick, Laura Fuller, Tobi Philips, Vivek Khandelwal, Debra Boxill,
and Karen Jozefowicz, on the development, design, editing, and the production of
this book.
Finally, I would like to acknowledge financial support for the first edition pro-
vided by the Dean ­Witter Foundation and the Leavey School of Business at Santa
Clara University. Lastly, my wife Arna contributed many behavioral examples from
her own work ­experience. She was especially gracious about my having devoted
untold hours ­developing the manuscript and then producing this second edition.
Hersh Shefrin
Santa Clara University
Chapter One

Behavioral Foundations
The main objective of this chapter is for students to demonstrate that they can de-
scribe 10 specific psychological phenomena that impact the judgments and choices
that normal people make about decision tasks that feature risk. These phenomena
are divided into two groups: heuristics and biases, and framing effects.
After completing this chapter students will be able to:

1. Identify key biases that typically arise when people make judgments about risk.
2. Explain why reliance on heuristics, while unavoidable, leaves people vulnerable to
making biased judgments.
3. Recognize that framing effects lead people’s attitudes toward taking risk to be highly
dependent on the circumstances in which they find themselves.

1.1 TRADITIONAL CORPORATE FINANCIAL DECISIONS

AND PSYCHOLOGICAL TASKS
A wealth of psychological research over the last 50 years provides important in-
sights into how normal people make judgments and choices about risky alterna-
tives. Over the same period, research conducted by financial academics provides
important insights into how financial executives should consider making judgments
and decisions about corporate risk, and to some extent what executives do in prac-
tice. This book will help you to connect these two research streams, and in the
course of doing so it will provide you with insights about the degree to which psy-
chological pitfalls create imperfections in corporate decision making and reductions
in corporate value. The book will also provide guidance about how to create value
by mitigating vulnerability to these pitfalls.
To help fix ideas, consider a small example. Imagine a firm is contemplating a
new one-year project which requires it to spend $3.2 million at the end of this year,
in the anticipation of receiving a return at the end of the following year. The project
is cyclical, as the financial executives at the firm believe that the actual value of the
future cash flow from the project will strongly depend on the state of the economy
during the next year. The project also features high risk, as cash flow will be espe-
cially high if the economy is strong but especially low if the economy is weak. Typi-
cally, for projects of comparable risk, the firm seeks an expected return of 35 percent.
1
2 Chapter One

Suppose that the economy was stagnant last year, and that economists’ current
outlook for next year is that there is a very high chance that growth will continue
to be stagnant. Suppose too that most economists agree that there is a low chance
of moderate growth and a very low chance of a boom. The consensus view is that
a recession is not likely, but if one materializes it is half as likely to be severe
as mild.
The financial executives typically rely on these forecasts to form their own judg-
ments, which they combine with other information such as recent stock market per-
formance. In this regard, the stock market increased by 25 percent during the last
twelve months, the stock of the average firm in their industry increased by 18 per-
cent, and the stock of their own firm increased by 12 percent.
In assessing their proposed project, the executives estimate that its cash flows
will be $46.9 million in the event of a boom, $31.9 million if the economy exhibits
moderate growth, $1.9 million if the economy is stagnant, −$8 million in the case
of a mild recession, and −$13 in the case of a severe recession.
Put yourself in the position of a financial executive who has the responsibility of
deciding whether to adopt this project. Suppose that you place a lot of trust in the
cash flow estimates, as well as in the economists’ general assessment. Would you
feel that you have enough information to make an informed decision about whether
to adopt the project?
The standard textbook approach to project selection revolves around discounted
expected cash flows. In theory, the computation of expected cash flows would re-
quire quantitative probabilities for the alternative states of the economy, not simply
the qualitative descriptors mentioned above. Therefore, financial executives who
sought to base their decision on the kind of reasoning found in traditional corporate
finance textbooks would need to convert the economists’ qualitative descriptors,
along with other information such as stock market performance, into numerical
probabilities. Imagine that they do so, and assign a probability of 6 percent to a
boom, 1 percent to moderate growth, 90 percent to a stagnant economy, 1 percent
to a mild recession, and 2 percent to a severe recession. Exhibit 1-1 summarizes the
information in this example.
Based on the executives’ probability judgments, the expected cash flow from
the project would be $4.5 million, whose present value at 35 percent turns out to be

EXHIBIT 1-1 Forecasted Cash Flows for a Hypothetical Project, with Associated Gains and Losses, Conditional on
the Future State of the Economy Along with Economists’ Qualitative Probabilistic Assessments and
Managers’ Quantitative Probabilistic Assessments

Economists’ Probability Managers’ Probability Cash Flow

Future State of Economy Assessments Assessments Cash Flow (Gain/Loss)
Severe recession Highly unlikely 2% –$13.1 –$16.3
Mild recession Not likely 1% –$8.1 –$11.3
Stagnant economy Very high chance 90% $1.9 –$1.3
Low-to-moderate growth Low chance 1% $31.9 $28.7
Boom Very low chance 6% $46.9 $43.7
 Behavioral Foundations 3

$3.4 million. Notably, $3.4 million exceeds the $3.2 million required capital investment,
which according to traditional textbook analysis suggests that the financial executives
should adopt the project.
There are two important psychological points to note in the example. The first
point pertains to the fact that the financial executives were not given quantitative prob-
abilities, but instead had to make their own subjective judgments about what numbers
to use, based on a mix of qualitative and quantitative information available to them.
Notice from Exhibit 1-1 that executives assign a probability of 6 percent to a boom,
which is much higher than the 1 percent they assign to low-to-moderate growth. Given
that economists characterized low-to-moderate growth as being more likely than a
boom, financial executives’ probability assignment might reflect judgmental biases
or a psychological tendency to overweight probabilities of extreme events. A similar
remark applies to the probabilities that executives assign to a recession.
The second point concerns the gains and losses associated with the project, where
the gain is expressed as “payback” defined as cash flow minus initial investment.
See the rightmost column in Exhibit 1-1. Notice that the probability of the project
incurring a loss is 93 percent, with gains being generated if the economy grows.
Psychologically, being super sensitive to losses might lead the executives to reject
the project, despite its positive net present value.
The two points just mentioned relate to the primary focus of this chapter, whose
purpose is to introduce ten specific psychological phenomena that underlie the be-
havioral approach to corporate finance. To be sure, there are other psychological
phenomena discussed in the book, besides the ones introduced in this chapter. How-
ever, the ten phenomena that form the heart of this chapter provide the foundational
material for everything else in the book.
Notably, these ten phenomena impact investors just as they impact the managers
of a firm. Investors also form judgments about firms’ future cash flows, especially
when they face choices about trading the securities of those firms. An important
issue that arises in the behavioral approach is that both managers and investors often
need to consider the psychological phenomena impacting other people, as well as
themselves, when making their own judgments and decisions.

Dual Systems
heuristic In this chapter you will learn about biases associated with heuristics, or rules of thumb,
A rule of thumb used to upon which people rely in order to arrive at their judgments and make decisions, as
arrive at a judgment or well as how people’s choices are influenced by the manner in which they frame their
make a decision.
decision tasks with respect to gains and losses. Accordingly, the remainder of this
frame chapter is organized into four main sections, the first three of which are respectively
Synonymous for devoted to biases, heuristics, and framing effects; these sections introduce and de-
description. scribe 10 specific psychological phenomena. The fourth section discusses psychologi-
cal and neurological frameworks to explain the factors underlying people’s judgments
and decisions about risk, as well as ways to improve both of these tasks.
System 1
The fast, automatic, and in- Many aspects of the 10 phenomena take place below the level of consciousness.
tuitive processes associated In this regard, psychologists suggest that we can think of our brains as having two
with thinking. systems, an intuitive system they call System 1, which is fast, and a more deliberative
4 Chapter One

System 2
The slow, deliberate, con-
scious processes associated
with thinking.
system they call System 2, which is slow. Although both systems engage in calcu-
lation, we are consciously more aware of the calculations when they are done by
System 2, such as computing the present value of a stream of cash flows. The cal-
culations performed by System 1 are more automatic, such as when making a turn
while driving a car or running to catch a ball.
The operations that System 1 makes are quite impressive, given the absence of
conscious calculation. At the same time, human intuition is imperfect, which is why
we are prone to make errors in judgment and choices that are imprudent. It is easy
to suggest that the remedy is to rely on System 2 for judgment and decision making.
However, System 2 requires much more effort than System 1, and we typically lack
the mental resources and capabilities necessary for System 2 perfection.
The term “dual systems” is shorthand for the System 1/System 2 conceptual
framework. An important reason to study behavioral corporate finance is to inves-
tigate how dual systems influence judgments and decisions that are made in a cor-
porate financial environment. In this regard, much of what is taught in traditional
corporate finance textbooks pertains to processes that System 2 carries out. Behav-
ioral corporate finance adds explicit consideration of System 1 issues to the mix,
with the intent to help managers make better decisions.
The next three sections discuss the results of experiments that psychologists have
used to uncover the 10 psychological phenomena that form the heart of this chapter.
In order to appreciate the discussion that follows, it is vitally important to complete
the behavioral questionnaire, which is available in Additional Resources to Chapter 1.
This questionnaire can be downloaded from the book web site at www.mhhe.com
/shefrin2e. After completing the behavioral questionnaire, please continue your read-
ing of this chapter, which provides a detailed discussion of each of the 10 phenomena.
Each of the next three sections is divided into subsections, with each subsection
introducing one of the ten foundational psychological phenomena. The subsections
feature a three-pronged 3-D structure, namely: description, diagnostic question, and
discussion. A subsection begins with a brief description of a psychological phenom-
enon. This is followed by an example of a diagnostic question that psychologists
have used to identify the phenomenon in question. The ensuing discussion indicates
how people generally respond to the question, and what the response pattern means
for the phenomenon being discussed.

1.2 BIASES
Bias A bias is a predisposition towards making a specific type of error.
A predisposition toward
making a specific type Excessive Optimism
of error.
Description
Psychologists have concluded that people are excessively optimistic, by which they
mean unrealistically optimistic. More precisely, people tend to overestimate how fre-
quently they will experience favorable outcomes and underestimate how frequently
they will experience unfavorable outcomes.
Another random document with
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compliments at this period were the most spontaneous of his life.
There was no doubt that he was very proud of her, and once he went
so far as to hint that he felt rather sorry for the majority of men.
The month at Beaumanoir was rather fatiguing, but very gay—at
least, everybody laughed a great deal, and seemed full of energy.
Emmy came for a few days, and Lady Mary Gifford remained a
fortnight, and bestowed much of her society on Lee.
When they returned to the Abbey there was still more or less
shooting and hunting, but Cecil applied himself seriously to the
imminent elections. As time passed, and the defeat of his party
loomed large in the possibilities, Lee noted that his interest became
less impersonal and considerably more acute; his latent ambitions
and energies felt their first prick.
He spoke frequently at this time, and as the roar of the storm grew
nearer, his own accents lost the cold deliberation of the first weeks
and became impassioned and convincing. He had little doubt of his
own election, but the threatened downfall of his party harassed and
angered him. It was then that his wife discovered that he had not
outlived his boyish love of sympathy; and the boudoir in the tower
and the lonely moorland were the scenes of many long and intense
conversations, until it became his habit to demand the sympathy of
his wife for every strait, great and small, in which his country and his
party found themselves.
If a solid winter of politics bored Lee, her husband never knew it.
Neither did Lord Barnstaple, who watched her critically; he had no
more intimate talks with her. But although she was destined to find
much in English politics more interesting than Home Rule, the
present crisis was certainly exciting. And the two facts, that Cecil
was expanding, not solidifying, and that he showed signs of
becoming almost dependent on her, were satisfying alike to the pride
of her purpose and to the might of her affections.
On the first stormy day, Cecil announced his intention to begin the
course of study he had planned, and was surprised and gratified
when his wife invited him to bring his tomes to her boudoir.
“I’m tired of novels, and I’ve nothing else to do, and I’m so
tremendously interested myself, that I think I’ll read with you,” she
said, as Cecil littered her lapis-lazuli table. “Would it bore you to
explain things to me?”
“You are sure it wouldn’t bore you?” Cecil looked across the ugly
volumes at his beautiful wife, his eyes sparkling as eagerly as when
she had, ten years ago, at the Cliff House, put into words his half-
formed desire for an adventure. “I should like it—above all things.”
“I should be much more bored roaming round the Abbey by myself,
or sitting here twirling my thumbs. I think I can understand. I’ve read
The Times every morning for three months, and I feel equal to
anything.” She did not add that at each finish she invariably stuck a
pin up to its head into the pride of England, lest her surcharged
spirits find vent upon the gentlemen of her household.
“You can understand anything,” replied Cecil, who did not appreciate
the humour of her remark. “And I’ll get along twice as well myself if I
have somebody to talk things over with. But you mustn’t tire
yourself.” And he went over to the other side of the table.
They read together the long winter through, seeing Lord Barnstaple
only at the table and in the evenings: he had congenial spirits in the
neighbourhood, and he paid several visits to London. The
conversation between the three was invariably of politics. When the
weather was fine Cecil and his wife spent two or three hours of every
day out-of-doors, and occasionally attended a meet.
The fascination of politics, when the mind has fairly opened to them,
is indubitable; and Lee not only felt proud of herself that her
understanding and her patience stood the strain of this mass of facts
—whose skeletons fairly rattled—which mounted higher and higher
on her lapis-lazuli table and encroached upon the divan and all of the
ancient chairs, but she took a keen mental delight in the acquiring of
knowledge; and what knowledge to the alert modern mind can equal
the charm of current history? Although her primary purpose was to
bind her husband to her by every fetter she could devise, she
occasionally saw herself the centre of a political salon, when the
world had pronounced her the brilliant wife of a great man.
It was not later than the beginning of the second month of their close
mental intercourse that Lee made one of her most important
discoveries regarding her husband; he had intellectual heights and
depths which she would never touch. She had cleverness far above
the average of her sex, and, had she chosen, she would have had
every right to pose as an intellectual woman; but she had distinct
limitations, and one proof of her cleverness was that she recognised
and accepted them. The discovery arrived in the wake of a pleased
reflection that it was certainly a privilege to be in constant contact
with a mind like Cecil Maundrell’s, and that she was distinctly
grateful for it. For a time she was mortified and depressed, for it was
her first intimation that she was not all that the gods or man could
desire; but it was her mental habit to face facts and digest them, and
when this was disposed of she considered its possible results. Her
conclusions soothed her. She knew something of men. When Cecil
tasted to the full the sweets of masculine superiority over the mate
with whom he was so delighted, and of whom so justly proud, there
would be still another bond between them. Far be it from her to
attempt to throw dust into his keen eyes by feminine blandishment
and subterfuge; she admitted the truth, whenever the opportunity
offered, with spontaneous bursts of admiration; and if Cecil had not
been flattered he would have been less than human.
“I don’t see how I shall ever be permitted to become discouraged,”
he said one day with some humour, looking into the rapt and
beautiful eyes opposite him. “I believe if I made an egregious ass of
myself in the House, you would persuade me that I was too great to
be understood by my fellow-men.”
“I’m not a goose, thank you. But you’ll never make an ass of
yourself, so it doesn’t matter. Of course you’ll be a great man.”
“I wish I could believe it.”
“It’s plain enough to every one else. All you need is ambition, and I
can see that growing already. If your party is defeated, so much the
better for you. You can devote your energies and your gifts to putting
new life into it. You’re just what the old fogies need. I don’t see how
you could start out more favourably, and I don’t see what is to
prevent your being the next great man.”
Cecil’s nostrils quivered suddenly. He looked for an instant longer
into the eyes that had expressed many more things to him than
admiration for his intellectual equipment, put out his hand impulsively
and took hers, then returned to his studies.
 CHAPTER IX
THEY moved up to town on the third of April. Lady Barnstaple had
taken a tiny and costly house for them in Green Street, and as there
had been much correspondence on the subject, and many samples
had travelled from London to Yorkshire and back, it was almost in
order when the young couple arrived to take possession.
“For goodness’ sake, have it light and bright,” Lady Barnstaple had
written. “London is such a grimy hole, people simply love colour.
Don’t mind bothering me; if I were poor I’d be a house decorator. The
only fault I had to find with the Abbey was that it was furnished.”
Lee found her doll’s house a delicious nest of colour and luxury after
the feudal severity of her tower; and although Cecil was even more
serious than when he had married, she managed, during that first
spring in London, to make him feel that they were playing at keeping
house and at the lighter side of life. She could always amuse and
interest him when she thought it wise to do so.
They went out very little, for he detested crushes in hot ill-ventilated
rooms, and large dinners were not more to his taste; but he liked the
play, and they were always to be seen at Tattersall’s on Sunday
afternoons, and often in the Park, which had not yet been vulgarised
as a promenade. In the mornings they rose early and rode either
through the Park with the many of stereotyped habits, or out into the
country; occasionally to Richmond, where they breakfasted at the
Star and Garter, and tried to imagine that it was still brilliant and
wicked. Sometimes, of an afternoon, they traversed three or four “At
Homes,” where Lee had an enchanting sense of being in the great
world at last, and Cecil kept his eyes longingly on the windows. At
the play they always took a box, as Cecil became restless in the
narrower confines of the stalls, and Lord Barnstaple and Mary
Gifford usually accompanied them. Lady Barnstaple, although she
sang her daughter-in-law’s praises in a loud high key, flatly refused
to elevate her passing charms into a box of which Lee was the
radiant and novel star. Lee was greatly admired, and knew that she
could have been the bride of the season, had Cecil permitted; but
although she felt some natural regret, especially when her mother-in-
law expostulated, and Lady Mary Gifford commiserated, on the
whole she did not care. Cecil barely let her out of his sight, and once
he sulked for an entire day because she went to a luncheon; she
was happy, and nothing else mattered. When she was stared out of
countenance at the opera and theatre he took it as a matter of
course, but the newspaper comments were less to his taste, and he
peremptorily forbade her to give her photograph to any of the
illustrated weeklies, or to be the heroine of certain enterprising “lady-
journalists,” who wished to exploit her beauty and her many
delectable gowns. Her semi-seclusion gave her a touch of mystery,
and one woman’s magazine would have made her known to fifty
thousand provincials; but Cecil was disgusted at the bare idea of
sharing his wife with the public, and flung the artful request for an
interview into the fire. Lee was much amused, and assured him that
Mrs. Montgomery had brought her up to regard notoriety with horror.
“And after all,” she said to Lady Barnstaple, “suppose I did become a
professional beauty, that would place Cecil in a contemptible
position, and I’d rather be a desperate failure than do that.”
“Oh, bother! But it’s no use talking to a woman in love. You’ll sacrifice
your youth to a selfish brute of a man and spend your thirties
regretting it and your forties making up for lost time. I love Cecil, and
of course I’m glad to see him happy, but he’s as selfish as all men,
and you’re making him more so. I don’t say you won’t keep him. I
believe you will, for he’s the sort that would rather be faithful to his
wife than not—doesn’t take after his illustrious parent—but he’ll soon
take you as a matter of course, and then you’ll realise what the world
could do for you. God knows what I should have done without it, and
if I ever have to go under, a dose of laudanum will do the rest.”
But Cecil gave no sign of taking his wife as a matter of course. It is
true that he took all and gave nothing—except his love. That Lee
might have an inner life of her own never crossed his mind; that it
had ever crossed any one’s else that she was fitted for a career
more or less apart from his own, however parallel with it, he would
have resented as an insult to them both; and he had long since
dismissed from his thoughts certain complexities which had puzzled
and worried him during the weeks of their engagement. He was
perfectly satisfied with her; although he had begged to be released
from paying her compliments, and had received his discharge, he
would have had her changed in nothing. Her beauty and passion
held him in thrall, and he was more than grateful for the
companionship she offered him, to say nothing of the incense. He
would have liked to be rich that he might have had the pleasure of
making her many beautiful presents, but he was philosophical, and
wasted no time in regrets. And he was not wholly an egoist, for he
occasionally reminded himself that he was the luckiest chap alive;
and when he glanced along the future, and reflected that for each of
the severe trials, mortifications, and disappointments of his public
career he should find solace, and even forgetfulness, in his home, he
felt that there were indeed no limits to his good fortune.
Did he ever think of Maundrell Abbey at this time? He gave no sign.
But possibly he saw no reason for anxiety. Emmy was entertaining
magnificently, and had informed her family that Chicago had taken a
sudden leap in the direction of certain of her town lots, and trebled
their value. Lee, in spite of the gossip with which Lady Mary Gifford
regaled her concerning almost every woman in Society, was not
inclined to think evil spontaneously of any one, but she overheard
one woman say to another, with a shrug of the shoulders, that “Lady
Barnstaple had taken up with the wrong man,” and she was
surprised at the constant presence of Mr. Algernon Pix in her
mother-in-law’s house. Mr. Pix had none of his sister’s aristocratic
beauty, although he was good-looking in a common way; he was
very dark, with eyes set close together, and he had a neat little
figure. His manner was polite to exaggeration, but his accent was
fatal, and three years of Society had not curbed his love of
diamonds. In truth, his position was very precarious. Some women
liked him, but the men barely accepted him, despite the determined
bolstering of several of Victoria’s powerful friends; and as he had
never even attempted to handle a gun, and feared a horse as he
feared the snub of a Duchess, his social future ran off into vague
perspectives. He was wise enough never to accept invitations to the
country, and Lee had not met him until she moved up to town. He
was the sort of man whom she had heretofore associated with
drapers’ counters and railway trains, and inevitably she snubbed
him.
“I’d be very much obliged to you if you’d treat my friends decently,”
said Lady Barnstaple sharply, when they were alone.
“Surely he is not a friend of yours.”
“His sister is my very most intimate friend; and as for him—well, yes,
I do like him—immensely. It means something to me, I can tell you,
to have a man show me the thousand and one little attentions that
women love—and to think me still beautiful; and he does. I don’t say
he would if I were not the Countess of Barnstaple, and miles above
him socially—I’m no fool—but that he can be really dazzled means a
great deal to me, and when you’re my age you’ll know why.”
Lee reflected that probably the bond between them was the
commonness of both, and that “Emmy” was a striking instance of
heredity, then dismissed the subject from her mind. Lord Barnstaple,
who never took a meal in his wife’s house, except in company with
many others, and took many at the little house in Green Street, was
apparently unaware of the existence of Mr. Pix, although he
commented freely, and with caustic emphasis, upon the
idiosyncrasies of his legal wife.
 CHAPTER X
ON June twenty-eighth Parliament was prorogued for the elections,
and Cecil and Lee went to Yorkshire at once.
Lord Maundrell made a number of speeches, made himself
agreeable to many men whom he would have preferred to kick, and
received his nomination. The contest was bitter and exciting, and
Lee designated her husband during this period, for want of a better
term, as “less English” than she had yet known him. There were
times when he let her see just how perturbed and excited he was,
carefully as he secluded his inner mind from others. Lee, in the little
stone villages, that looked as if they might have been built by the
heirs of the cave-dwellers, played the part made familiar to her by
the novel and the stage, and, for the life of her, could not take herself
seriously. Her difficulty was increased by the fact that she could not
understand two words in ten of the Yorkshire dialect. The villagers
understood her as little, but there was no doubt that her uncommon
beauty and her gracious and magnetic manner duly impressed them.
Cecil was returned, but his party was defeated; and he convinced
Lee that without her his melancholy would have lasted fully a month.
There were still two weeks before the twelfth of August, and they
took a run over to Normandy. After their return, life until December
was precisely what it had been the year before. The same people,
almost without exception, came in four instalments to the Abbey for
the six weeks which followed the opening of the grouse season, and
it seemed to Lee that they talked about precisely the same things.
The men spent the day on the moors, and at dinner talked when they
felt like talking at all, of the bags which had been made, the condition
of the birds and the moor, and the weather prospects, occasionally
indulging in reminiscences of other years. The women played tennis
and golf, rode or drove, or sat about the Abbey. After dinner the men
roused, and permitted themselves to be flirted with, either in historic
boudoirs or across the billiard tables, and there were many who
played high and late. Cecil and Lee usually started on their long walk
to the tower about midnight after a long and fatiguing day.
When Emmy’s guests had gone, Lee went out with Lord Barnstaple,
her husband, and half a dozen other enthusiasts, and persuaded
herself that sport was really absorbing whether one had been
brought up to it or not. It was certainly preferable to wandering all
day long by oneself over an immense and echoing Abbey, or driving
to neighbouring estates, and taking tea with women who rarely went
up to London.
When the hunting season came, although the novelty of riding hard
after a yelping pack with some twenty men in beautiful pink coats, or
even of dancing with the latter at hunt balls, was no longer a part of
her pleasure, she felt that the chase would wear when other things
had palled, although she would have been glad to return to the
Abbey for December. They visited, however, and they hunted, and
they shot; they graced farmers’ balls and hunt races with their
presence, and they even attended a great magic-lantern show; only
returning to the Abbey for a few days at Christmas. Lord Barnstaple
went to Paris, and the young people were alone. It was a blessed
interval of rest, during which Lee exacted from Cecil a solemn
promise that he would not mention sport, adding hastily that she
adored it, but was horribly jealous, and did not want him to think of a
thing but herself for an entire week. And to his credit it must be said
that he seemed to find no difficulty in humouring her.
In January they went to Paris for a fortnight, as Lee’s wardrobe
needed replenishing, and in February Cecil’s parliamentary duties
began, and they settled down in London when it was at its dreariest
and ugliest, and the rest of England was moist but beautiful. Lee was
alone now, for the greater part of the week, from three in the
afternoon until midnight or the small hours of the morning, although
she frequently went to the Ladies’ Gallery of the House and brought
Cecil back to dinner; or took tea with him on the Terrace, which she
thought very interesting. There was always—for a reasonable time—
at least one distinguished man to be pointed out, and she liked to
conjure up the days when the Thames was gay with the barges of
sovereigns and their courtiers, instead of mildly picturesque with
penny boats and queer-looking water vehicles for which Cecil had no
name.
When the young member was not too busy they still rode or walked
in the morning, and attended the play or the opera at night.
Occasionally they went to a dinner or a party, and as Emmy’s
entertaining this year took the form of morning concerts, with divas
and tenors to beckon the fickle world, Cecil made a martyr of himself
upon these occasions as gracefully as he could.
On the whole, Lee, although she left a good many cards and
received on Tuesdays, saw less of Society than during the preceding
season, and learned of its doings and of what faint interest it still felt
in her from Lord Barnstaple and Mary Gifford, who came frequently
to luncheon or tea. However, she assured herself that after the late
hours of the autumn and early winter she was glad to get her beauty
sleep again, and went to bed at ten o’clock.
When there was an important debate on in the House she always
attended, and more than once came home with Cecil at two in the
morning. Such speeches as she did not hear she read next morning,
as well as the comments thereon in no less than six different
newspapers; and she frequently assured herself that her political
education was comparable with that of any Englishwoman born. Her
enthusiasm undoubtedly had its reward, for not only was Cecil
pleased and grateful, but when they attended dinners of more or less
political significance she invariably incited her partner to speech, no
matter how silent Heaven had made him. One, and he was famous
and stout, and had buried conversation with other follies of his past,
surprised himself by informing her that she could talk politics with her
eyes more eloquently than any woman in England with all the
resources of a large vocabulary and all the ambition inspired by the
heroines of Disraeli.
Lord Barnstaple laughed when she related this anecdote.
“Oh, you will be wanting a salon next,” he said. “It is quite natural you
should picture statesmen crowding your rooms—I am making no
reflection on the size of your house—and whispering their secrets in
your pretty little ear—or seeing themselves upside down in your
eloquent eyes.”
Lee coloured and lifted her chin in a manner which even a father-in-
law must find charming. “I could have one if I liked—and that quite
satisfies me, thank you.”
“I’m sorry you can’t go out more, though,” he said tentatively. “You
are young and admired, and of course you like what women call
pleasure.”
“I don’t care a rap about it,” she said with emphasis. “I am sure one
hard London season would bore me to death.”
“Quite so. Quite so. It’s just a beastly grind, nothing more. You’re
really far better off in the way you have chosen. I am glad to see you
so happy. Cecil is certainly a lucky dog.”
“You gave me some good advice that day.” She smiled brilliantly into
his watchful eyes.
“Oh, you were quite clever enough to have arrived at the same
conclusions without my help. Of course if you had wanted a flashing
career of your own, or had been a silly woman, greedy for admiration
and intrigue, it would have been a different matter—a terribly
different matter for Cecil. But you wanted happiness, and there is
only one way to get it.”
 CHAPTER XI
IT was not long before Cecil’s abilities were recognised. Something
was expected of him, for he came of a line of able Parliamentarians;
and as he was already famous as a sportsman, he commanded an
interest by no means inspired by the average young man of an
illustrious house.
When the time came for him to make his first speech, shortly before
the end of the Session, Lee sat in the gallery with an icy exterior
surrounding a furious nerve storm. The day was dark and
depressing. Those long rows of faces had never looked more
apathetic; it was enough to make a novice feel, as he rose and
confronted the bored old veterans, that he was on trial for his life. If
Cecil failed Lee felt that she could hate him, not because the world
would curl its lip, but because Cecil, mortified, stammering, a failure,
would be an ideal in collapse. She might oust these unworthy
sentiments later, and sympathise with him in his distress, but she
could never quite rehabilitate him. He might be defeated in the most
significant climaxes of his career, his party might turn upon and rend
him, and she would pour all the wealth of her nature at his feet, but if
he made a fool of himself, she’d never forgive him.
But Cecil had no intention of making a fool of himself. Moreover, his
training at Oxford, when the Union had rung with his salad
eloquence, made itself manifest among the other foundations of his
mind and character. He was neither nervous nor too diffident. In fact
he opened so easily that Lee thrilled with pride and excoriated
herself. When he got his first “Hear!” her knees jerked; she realised
how excited she was, and glanced about the gallery hastily; but in
that dim cage she had little to fear. He demanded the attention of the
House for something over an hour, and he would have scorned to
amuse it; but his speech was terse and packed with his own thought;
it had not a platitude in it, nor a time-honoured sentiment. He might
or might not become a brilliant speaker when he had acquired
sufficient practice and confidence to let himself go, but that he was a
Maundrell to be reckoned with had been conceded long before he
sat down.
Lee was with him in the lobby when he received the congratulations
of men many years older than himself, and the next morning she
brought all the newspapers, and pasted the highly laudatory articles
on the rising sun into a scrap-book. She cunningly persuaded him to
be photographed, and as his reputation waxed she supplied the
weekly papers with his distinguished profile. He was moved to wrath,
but his wife’s fervid admiration was very sweet to him, and when she
pleaded it as her excuse for taking a step without consulting him, he
forgave her instantly.
They could not get away in time for a trip abroad that year, much to
Lee’s disappointment; for the Continent was one vast romantic ruin
to her, varied with shops and the picturesque costumes of peasants.
The late summer and autumn and early winter were precisely like the
summer and autumn and early winter of the year before. They
entertained the same people, visited the same houses; and this time
Lee had the novel feeling of amazement for a people who were just
as much pleased and just as absorbed as if a benign Providence
had gifted them with the instinct for variety.
“No wonder they are great,” she thought, with a sigh.
In January the London maisonnette was open again, and as gay as
flowers and upholstery and lamp shades could make it. Cecil for
some time past had meditated a Bill for the relief of certain
manufacturers, and had worked at it on odd days during the recess.
He introduced it, and it failed, for it was practically a demand for the
exclusion of much that was “made in Germany,” and was regarded
as a covert and audacious attack on Free Trade. His Speech in its
behalf was the most brilliant he had yet made, and he was bitterly
denounced by the Liberal and Radical press next morning. Nor did
their attentions cease with their comments on his Bill and Speech.
From that time on he was regarded by the Opposition as a man to be
sneered into the cooler regions of private life. His constituency was
warned by that section of its press whose principles he did not
represent, and he was accused of having pledged his abilities, “such
as they were,” to a life-long fight against progress, and of a criminal
indifference to Home Rule and to the unfortunate Armenian.
Of these jeremiads—which Cecil refused to read, having made up
his mind and being at peace with his conscience—Lee was as proud
as of the many compliments which the young member received, and
she pasted them dutifully in the scrap-book. Of Society she saw
something less than ever, although her mother-in-law adjured her not
to “make a fool of herself.” She admitted that she should like to go to
some of the great parties, and to an occasional supper at the Savoy,
under Lady Barnstaple’s wing; for her evenings were lonely, and
politics would have been even more interesting if seasoned with
variety. She asked Cecil, with an apologetic blush, if he would mind.
He plunged his hands into his pockets.
“Are you very keen on it?” he asked.
“Oh, I’m not mad about it, but I haven’t seen much of London
Society, and it interests me; and I have so much time on my hands.”
“I’m afraid you must get rather bored. I’m sorry I have to be so much
away from you. But—I hate to see women running about without
their husbands. Besides it’s always the beginning of the end—when
a woman goes her way and a man his. It’s selfish of me, but I like to
think of you as always here. As you know, I break away sometimes,
and come home unexpectedly——”
“You haven’t this year.”
“We’ve been so confoundedly busy. But I often think of you, and I
like to picture you in this room with a book, or asleep when other
women are baking their complexions.”
Lee smiled. “That was very astute. You would rather I did not go out,
then?”
“I feel a selfish brute. Let me know what you particularly want to go
to, and I’ll try to pair and take you myself.”
But Lee knew that he hated the very thought of it, and he was more
and more absorbed in his work. Of his ambition there was now no
question; he had even gone so far as to half admit it to her. He did
not return to the subject, upon which their conversation had, indeed,
been so brief that he might be pardoned for forgetting it. Lee
attempted to find oblivion in the mass of data elucidative of colonial
history, past and present, to which Cecil, with his usual
thoroughness, was devoting his leisure. It had been his purpose,
from the moment he had decided upon his career, to achieve a full
and sympathetic understanding of the colonies. He had given no little
attention to politics in India and South Africa, as well as to their
peoples, during his sporting tour, and he intended to revisit these
and other parts of the Empire as soon as he felt reasonably sure of
his footing at home, and had mastered the enormous bulk of colonial
conditions in the abstract. He had no belief in home-made theories
for governing the alien millions of the English race.
Lee looked forward to these journeyings with some interest, although
she would have preferred to explore the crumbling and rather more
picturesque civilisations of Europe. Travel would be more
comfortable, and the Continent was a superb theatre, under superb
management—to take it seriously was out of the question; but
although it did not appeal to the soul, it was a delight to the
imagination. But neither the one change in her programme nor the
other seemed imminent; Cecil found too much to do in England. The
present routine bid fair to last for three or four years to come.
And to have argued that social success would have conduced to her
husband’s advancement would have been a waste of words, for
Cecil was a man of ideals and regarded meretricious connectives
with scorn. He was very much elated at this period, for there was
every indication that the Liberal tenure was a brief one, and that his
party was regaining all it had lost, and more. He intended to speak
throughout the North, pending the next elections, and he had good
reason to anticipate that his services to his party would be rewarded
with that first stepping-stone to power, an Under-Secretaryship. Lee
was to go about with him, of course; he would as soon have thought
of leaving one of his members at home, and she looked forward to
the variation of the usual autumn programme with some enthusiasm.
She was tremendously proud of her gifted and high-minded young
husband, and when disposed to repine, forced into her mind her ten
years of unremitting determination and desire to marry Cecil
Maundrell, and her girlish hopes and dreams, some of which had
certainly been realised.
It was just after the Easter recess that he began to feel the need of a
secretary, for he was doing certain work outside the House. Lee
disliked the idea of a stranger in her maisonnette, to say nothing of
the fact that she would see less of her husband by many hours, and
offered herself for the post. He was surprised and delighted, for he
was reserved almost to secrecy with every one else, and had
contemplated admitting a stranger into the privacy of his study with
much distaste.
“Are you sure it won’t tire you?” he asked fondly. He was always very
careful of her.
“Of course not! And I haven’t a thing to do, now that all my clothes
are made. I’m sick of the sight of Bond Street. You know I love to feel
that I am of use to you.”
“You are always that, whether you are doing anything for me or not.
I’m quite selfish enough to accept your offer, if you really mean it. I
simply hated the thought of an outsider. But if I find it tires or bores
you, we can put a stop to the arrangement any day.”
It bored her, but he never knew it. As she had an exuberant vitality, it
did not tire her, although she sometimes felt very nervous. She
marvelled at the greatness of the masculine mind which could
master such details and find them interesting, and wondered if she
were a real politician after all. Somewhat to her amusement, she
found herself looking forward with pleasure to the sporting season; it
would be an interval of comparative liberty and rest. She enjoyed the
sensation of being useful to her husband, and the increased
companionship; but it was trying to spend so much of the morning
indoors, and to sit up by herself copying, when she preferred being
in bed, or reading such novels as were clever enough to satisfy a
mind now quite tuned to serious things. The theatre was neglected
during the last two months of the Session, for Cecil grew busier and
busier, and worked late on his off nights. Occasionally he examined
his wife’s lovely face anxiously to see if she were losing her colour,
or acquiring any little fine lines, and when he could discover no
outward symbol of injured health he begged her to tell him if she
were really equal to the strain. When she assured him that she was
profoundly interested, and had never felt better, he assured her in
return that she was, indeed, a wife of whom any man might be
proud. Sometimes she wished, with a sigh, that his wants were more
spiritual. She might revive her enthusiasm if he had need of
sympathy and solace, but the world was treating him very well, and
he was satisfied and happy. She wondered if he had ever been
anything else; he certainly seemed one of the favoured of earth.
 CHAPTER XII
A DAY or two before the end of the season Lee received a letter
from Mrs. Montgomery which suggested another variation in the
autumn programme. That lady and Randolph were leaving France
for England, and after a brief visit to Tiny they hoped to be welcome
at Maundrell Abbey. The junior Gearys, who were taking a belated
honeymoon (Mr. Geary had died a week after the wedding), would
arrive in England in the latter part of August.
Lee had seen nothing of her old friends since her departure from
California. Lord Arrowmount had amused himself with a ranch until a
month ago, when he had returned to England with his family, and
gone straight to his place in the Midlands. Mrs. Montgomery had
remained in California with them for two years, and spent the last
year with Randolph, who had bought a château in Normandy and
seemed to be devoting himself to the pleasures of the chasse. For
two years he had sauntered leisurely about the world, and had finally
made his home in France, as the sky and air reminded him of
California and the life did not. He had written Lee a brief note
occasionally, in which he said little about himself, and gave no
indication that his sentiments towards her were other than fraternal.
Nor could she guess what changes might have been wrought in him,
although he remarked once that the longer he remained away from
America the less he ever wanted to see it again. Out of the chaos of
Mrs. Montgomery’s letters Lee gathered that he was improved; but
she hoped that he was not too much changed, for with the prospect
of her old friends’ advent came a lively desire for something like a
renewal of old times. To her letter in behalf of Maundrell Abbey he
had never alluded, and she had not revived the subject, for she had
expected him to appear at any moment.
She went at once to the house in Upper Belgrave Street, and asked
her mother-in-law to invite the entire party to the Abbey for two or
three weeks in August and September. Lady Barnstaple happened to
be in a particularly gracious humour.
“I shall be delighted to see some new faces,” she announced. “One
gets sick of the same old set year after year. I quite liked Lady
Arrowmount, what little I saw her—rather prim and middle-classy,
but, enfin, quite convenable; one must not expect too much of the
ancient aristocracy of San Francisco. You’ve improved so much,
dearest. You never look shocked any more, and you’ve quite lost
your provincialisms. When you came you were like a sweet little wild
flower that had got lost in a conservatory. Now you are tout à fait
grande dame, and it is quite remarkable, as you go out so little. But
you always could dress, and the Society papers actually mention
your frocks, which is also remarkable. As a rule one has to be en
évidence all the time to retain any sort of interest. But you are pretty,
and Cecil is so clever—a selfish beast, though. How long are you
going to keep this thing up?”
“Oh, I am a mere creature of habit now. Who else is going down for
the twelfth?”
“Mary Gifford—couldn’t you marry her to Randolph Montgomery? It’s
really tragic the way she hangs on!”
“Her sisters have married, so I suppose she could. I don’t think she
wants to marry. Under all her loudness she’s a queer porcelain-like
creature, and rather shrinks from men.”
“Fiddlesticks! She’s waiting for eighty thousand a year! And she’s
quite right. Whether she’ll get it or not——she’s a real beauty, and
the way she keeps on looking just eighteen! Well, let me see: there
will be the Pixes——Mr. Pix has really consented to come at last;
never breathe it, but he’s been taking private lessons and has
actually learned how to shoot as straight as anybody. I think Mary
has her eye on him, but she’d better not!”
“Why not—since you are interested in her future?”
“Because I’m positive he’s the only man living that doesn’t see my
wrinkles, and in my pocket he’ll stay. Well—there will be the
Arrowmounts, Montgomerys, Gearys, Pixes, Mary, and sixteen or
eighteen of the usual crowd: the Beaumanoirs, Larry Monmouth, the
Duke and Duchess of Launcester, Lord and Lady Regent, and, oh,