Question

Please write 2-23 paragraphs providing a scientific and thoughtful opinion about this Behavioral Finance question.

One could argue that neither the classical finance assumption of rationality of investors is correct nor are the markets entirely irrational. Discuss the merits and demerits of these alternative philosophies about asset pricing.

Answer 1

Behavioral finance is the area of study that makes an attempt to understand the behavior of the investors in different situations so as to be able to predict the movement of the market. The classical approach states that investors are rational in nature. It means that the investors take decisions about their investments in the market after weighing all options and analyzing the optimal level of benefit or utility from the decision. The advantage of this is that the investor will take the best and the most profitable decision. The merit is that the movement of the stock market can be predicted if the investors behave rationally at all times. The demerit is that the market becomes predictable so it is advantageous for some investors who will benefit from it.

The other assumption i.e. the markets are entirely irrational, means that the market functions in a manner that is difficult to understand. There is no proper reasoning for the movement in the stock market. The demerit is that the market becomes highly unpredictable in nature. The merit is it becomes equally difficult for every investor to predict in which direction will the market move.

Therefore, the markets are neither completely irrational nor are the investors completely rational. There is a balance between the rationality of the market and the investor.