A Behavioral Theory of Real Options

Abstract

Strategic investment decisions often involve substantial uncertainty. Real options theory suggests a decision logic emphasizing the value of small initial investments that provide the opportunity to make additional investments after uncertainty is resolved. However, real options theory is grounded in financial market assumptions that ignore the challenges associated with the decision to exercise or terminate an option. We develop a behavioral theory of real options that formally embeds realistic assumptions about informational properties of the environment and behavioral properties of firms. We recognize that an option model of decision-making and a bandit model of experiential learning are fundamentally interrelated models of sequential decision-making under uncertainty. Our theory predicts conditions under which over- or under-execution errors (exercising or terminating an option erroneously) are likely, and policies that will shift the relative balance between them. One implication is that firms formally applying Black-Scholes mathematics are likely to overestimate the value of a real option.