Feb 03, 2020 11:32 AM EST
The Difference Between Traditional Finance and Behavioral Finance
Investing in anything from properties, gold, stocks or an essay writing website is a bold and risky move. But what most people don't know is that the decision to invest in those stocks is influenced by traditional and behavioral finance.
In traditional finance, there is the assumption that the investor and the market are rational. They gather or receive all the information they need and their decisions are based on that data. Therefore traditional finance simply states that investors don't make financial decisions on emotions.
In behavioral finance, psychology has a role in how people make financial decisions or investments. Behavioral finance explains that people are irrational and our own emotions and bias have a role to play when making investment decisions. For example, a student will order an essay online from a single organization. This is because of his past experiences therefore bias affects the decision to invest more in that organization.
This is what usually happens to investors when making a decision on what to buy and sell. This happens because investors might base their decisions on fear, overconfidence, gut feeling, what others are doing thereby following the crowd and past experiences.
With both traditional and behavioral finance having contrasting views of the financial and investing world. Here are the three main differences.
1. Traditional finance assumes that an investor is a rational person who can process all information unbiased. While behavioral finance draws from real-world experience stating that an investor has biases, it is irrational, and his emotions do play a role in the kind of investments undertaken. Take a student who needs academic writing help, for example. The student seeks writing help from an online firm or company and there are two companies to choose from. One is local while the other is foreign; the student will most likely choose the local company.
Why this is so is because just like an investor, the student own biases played a role in the decision. His bias of overconfidence and familiarity in the local firm made the student invest in it. Although the foreign company has a good track record and performance, the student will invest in the local company because of these biases.
2. According to traditional finances, investors receive unlimited knowledge, data, and information that are perfect. The investor carefully processes this information, therefore there's complete rationality. But in behavioral finance, investors have bounded rationality so the investor doesn't process all information. Regardless of how accurate the information is, investors are still bound to make an error in judgment.
3. Traditional finance states that the market is efficient and is a representation of the financial market's true value. This argument is based on the fact that traditional finance believes that investors have self-control. But behavioral finance believes that the market is volatile and that's why there are market anomalies. Here investors don't have perfect self-control, so limitations exist. The volatility of the market leads to the rising and falling of stock prices, so an inconsistent market.
Investors have to realize that a rational financial decision can be made, but they shouldn't fall into the trap of using emotions or urges to make an investment.
For instance, a student offers to do my homework for me and does it perfectly. If tomorrow that same student decides to run for student president. The decision to support him will be biased. This means that an investor can receive gifts or favors from a certain organization which will unconsciously influence his decision of either buying or selling stocks of the organization.
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