While traditional finance relies on the assumption of rational actors and efficient markets, behavioral finance provides a more nuanced understanding that incorporates psychological and emotional factors affecting financial decision-making. Both fields Arif Ahsan offer valuable insights, and combining elements from each can provide a more comprehensive understanding of financial markets and investor behavior.
This started me thinking. One approach would be on how each impact the other, and which one is more successful. You could survey people, determine which approach to investing (corporate, institutional, stock market) they use and then determine the result.
Here are a few articles for you.
Aguirre, R. A. A., & Aguirre, A. A. A. (2023). Behavioral finance: Evolution from the classical theory and remarks. Journal of Economic Surveys, 38(2), 452–475. https://doi.org/10.1111/joes.12593
Sharma, D., Misra, V., & Pathak, J. P. (2021). Emergence of Behavioural Finance: A Study on Behavioural Biases during Investment Decision-making. International Journal of Economics and Business Research, 21(2). https://doi.org/10.1504/ijebr.2021.10029893
Semoga Berjaya!
Donald H Noble, [email protected]
Stephen I. Ternyik thank you very much. I will follow up your suggestions.
Behavioral Finance is the application of psychology and human behavior to finance especially financial markets and asset prices behavior . Regular or normal finance is the application of economic and financial principles to the practices of finance and financial conventions and regulations .
The difference between the regular finance and behavioral finance is that the behavioral finance try to explain the decisions of investors from psychological approach and consider that investors are irrational especially in period of crisis, they are driven by fear, overconfidenc, bias...etc
- Market Assumptions: While behavioural finance assumes inefficiencies, conventional finance assumes efficiency.
- Investor Behaviour: Behavioural finance highlights biases and the conventional finance assumes rationality.
- Decision Basis: Behavioural finance takes into account emotions, whereas conventional finance uses logical reasoning.
- Focus Area: Behavioural finance studies psychology and the conventional finance focuses on models.
- Risk Perception: Behavioural finance explores subjective risk, whereas conventional finance quantifies risk.
Finance and behavioral finance are different. Finance is the study of money or management of money. In general, finance is classified in to three area as personal finance, corporate finance and public finance. However, behavioral finance is the Behavioral finance is the study of influence of psychology on the behavior of investors of financial analysts. Finance (the traditional finance) theory relies on rational choice theory: The idea that individuals will always make decisions that align with their best interests. Behavioral finance, on the other hand, seeks to understand why people make choices that are influenced by emotions, biases, and cognitive limitations.
Traditional finance assumes rational behavior, since trading in financial markets is likely to involve higher brain functions such as logical thinking, numerical calculation, and long-term planning. The concept of absolute rationality has emerged, where decisions in various fields should be made on a rational basis, to maximize profits regardless of other aspects. In the field of finance, when making any decision costs money and mistakes mean higher risks, a rational decision is based on current information about market analysis, financial data, and the internal and external environment, and then making a decision. A rational financial decision is one based exclusively on financial and economic indicators without taking into account non-financial factors (including emotions and attitudes) in achieving an effective exchange between risk / return.
As for behavioral finance, it is the study of the importance and role of emotion in the decision-making process of professional securities traders by measuring their physiological characteristics, some studies show that emotion actually enhances an individual's ability to make rational choices. Emotion allows people to go beyond the details, and set priorities that are consistent with economic expectations. Emotion is an important determinant of a trader’s ability to navigate financial markets; this means that we should consider the role of emotion indirectly. Specifically, aberrant financial behavior is often attributed to emotion. We believe that emotion is an important aspect of the human condition that can enhance decision-making.
These findings are consistent with current neurological evidence suggesting that automatic emotional responses such as fear and greed (e.g., amygdala-mediated responses) often outperform more controlled responses.
Emotions play a role in financial market decision-making. Emotions play a significant role in financial trading by analyzing the role of irrational elements of price movements in financial markets, and by analyzing the role of factors that are not based on the strength of rationality such as crowd psychology, greed, and agreements. People’s mistakes have been found to be linked to emotional processing areas. Hormonal factors may also play a role in emotional trading through the influence of risk.
Duraid Alshbib Thank you very much , Prof. Your discussion is very clear to me.
Core Assumptions Traditional finance assumes individuals make rational decisions based on available information and aim to maximize their economic utility. It also posits that financial markets are efficient, with prices reflecting all known information. In contrast, behavioral finance acknowledges that human decisions are often influenced by cognitive biases and emotions, leading to irrational behavior and market inefficiencies.
Decision-Making Process Traditional finance relies on utility theory, where decisions are made to maximize wealth or satisfaction based on data and probabilities. Behavioral finance, however, recognizes that psychological factors, such as overconfidence or loss aversion, often cause individuals to make decisions that deviate from rational predictions.
Market Efficiency Traditional finance is grounded in the Efficient Market Hypothesis (EMH), suggesting that stock prices always reflect all available information, making it impossible to consistently outperform the market. Behavioral finance challenges this view by showing that investor biases can lead to mispricings and market inefficiencies, creating opportunities for profit or loss.
Risk and Return Traditional finance defines risk in terms of volatility and uses models like CAPM and Modern Portfolio Theory (MPT) to assess and diversify risk efficiently. Behavioral finance introduces the idea that investors’ perceptions of risk are influenced by psychological biases, leading them to behave more conservatively or erratically than traditional models predict.
Investor Behavior In traditional finance, investors are assumed to act rationally, with the same access to information and similar risk preferences. Behavioral finance, however, explains that investors' decisions are often influenced by biases, emotions, and social factors, leading to suboptimal outcomes, such as holding onto losing stocks or following the crowd.
Market Anomalies Traditional finance tends to dismiss market anomalies as random events or temporary fluctuations. On the other hand, behavioral finance uses psychological principles to explain why anomalies like bubbles or overreactions occur, showing how investor psychology can lead to sustained price misalignments.
Financial Modeling Traditional finance relies on mathematical models to explain financial behavior, focusing on tools like the Black-Scholes model or portfolio management strategies. Behavioral finance incorporates psychological insights into financial models, recognizing that human biases can significantly impact financial decisions and market outcomes.
Impact on Policy and Regulation Traditional finance focuses on policies that promote market efficiency and minimize transaction costs. In contrast, behavioral finance suggests that regulations should account for investor biases, recommending measures to protect consumers from making irrational decisions and reducing the impact of herd behavior in markets.
Summary Traditional finance is based on the principles of rationality, market efficiency, and mathematical modeling. Behavioral finance, however, emphasizes the role of psychological biases and emotions in influencing financial decisions, challenging the assumption of rational behavior and highlighting market inefficiencies and anomalies. Both fields contribute to a broader understanding of financial markets, with traditional finance providing the theoretical foundation and behavioral finance offering practical insights into real-world investor behavior.
Behavioral finance incorporates psychological and emotional factors into financial decision-making, recognizing that individuals are not always rational, whereas traditional finance assumes rational agents who optimize utility; the two differ in how they interpret market behavior, with behavioral finance explaining anomalies like herding, overconfidence, and loss aversion.
Regular (or classical) finance assumes rational agents maximizing utility, while behavioral finance incorporates psychological factors like heuristics, biases, and emotions that influence investor decisions. Behavioral finance explains market anomalies like bubbles or overreactions that traditional models cannot account for.
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