Question

Discuss the differences of traditional finance and behavioral finance?

This questions contain 25 marks so please write in detail.

Answer 1

In general, traditional finance theory is founded on the notion that the market and investors are coherent. It further believes that the financial decision is based on the interchange of relevant information rather than emotions. This theory negates the argument that an individual’s psychology may work against them, thereby putting a negative impact on investment decision. In other words, the traditional finance theory relies on the assumption that the investors always behave in a rational manner and such a behavior also plays an essential role in overcoming tendencies. In addition to this, it considers that resources are always allocated efficiently, pricing is at par with intrinsic value and consistent with the efficient market hypothesis.

In contrast, the theory of behavioural finance takes into account investor’s psychology in financial decisions. This theory assumes that the investors may not behave in a rational manner and emotion plays a pivotal role in influencing the decision for investment. This theory relies on the supposition that in several occasions, the investors may respond to a nonrelevant information, leading to trading on noise rather than relevant data. It systematically depicts how the psychological behaviours such as chase trends, overconfidence, frame losses and lack of self-control affects financial decision making. It can be stated that while behavioural finance aims to address market behaviour and observed investor, the traditional finance is more inclined towards knowing how markets and investors should behave. The main difference between the two concepts can be further observed with the focus of traditional finance more emphasised towards the theoretical aspect decision-making rather than how investors behave in real-world.