Behavioral Finance vs. Traditional Finance

Behavioral Finance vs. Traditional Finance

SİNEM DERİNDERE KÖSEOĞLU
Copyright: © 2019 |Pages: 23
DOI: 10.4018/978-1-5225-7399-9.ch001
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Abstract

This chapter explored the development of behavioral finance theories from the traditional finance theories in detail. Traditional financial theory has assumed that investors are perfectly well-informed in making financial decisions for many years. However, the reality shows that these assumptions are not valid, especially over the last two decades. It is observed that investors exhibit irrational behaviors by acting with emotions even if they are well-informed. Because of the awareness of the importance human psychology in investment decisions, behavioral researchers have advanced their research in this direction. Thus, behavioral finance theories have been developed with this in mind.
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Traditional Finance Theory And Decision Models

This part of the chapter examines what traditional theories and their models are and includes all details about these.

The beginning of the classical economics is in the middle of the 18th century. Mill (1844), presented the notion of “rational economic man”, whose aim to maximize his utility by taking into account the constraints he faced. According to the aim of maximizing utility, the traditional finance theories have four foundation blocks:

  • 1.

    Perfectly rational investors;

  • 2.

    Efficient markets;

  • 3.

    Constructing portfolios depending on the rules of traditional Mean-Variance model,

  • 4.

    Risk-return trade off. Expected returns on investments are explained by differences in risk.

Modern portfolio theory dates back to 1950s. In 1952, Markowitz (1952) determined initial form of mean-variance portfolio theory. Sharpe (1964) adopted this theory as a definition of investor behavior and presented the Capital Asset Pricing Theory (CAPM). According to the CAPM, differences in expected returns are only determined by differences in risk. Fama (1965) also described efficient markets concept.

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