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Lakshay Tomer
Muskan Saluja
Investment Banking Fellow
22 September 2023
“Difference and Similarity between Traditional and Behavioural Finance”
To know the difference and similarities between Traditional and Behavioural Finance let us
first understand what is Traditional and Behavioural Finance.
Traditional Finance, In today's ever-evolving financial landscape, the concept of traditional
finance holds a significant place. Traditional finance refers to the conventional approach of
managing and investing money, relying on established financial institutions like banks, stock
markets, and mutual funds. This post aims to delve into traditional finance's key principles,
advantages, and limitations, shedding light on its relevance in an increasingly digital and
decentralized world.
For example, in traditional finance, individuals may choose to invest their money in a mutual
fund managed by a reputable financial institution. This allows them to diversify their
investment portfolio and benefit from the expertise of professional fund managers who make
strategic investment decisions on their behalf. However, one limitation of traditional finance
is the lack of accessibility for individuals in remote areas who may not have access to
physical banking institutions or stock markets.
Behavioural Finance, In a world where financial decisions are often driven by rationality
and logical thinking, behavioural finance delves into the intricacies of human behaviour and
psychology when it comes to money matters. This intriguing field explores how individuals'
emotions, biases, and cognitive errors influence their financial choices, shedding light on why
people sometimes make less-than-optimal decisions despite knowing better.
For example, In a world where financial decisions are often driven by rationality and logical
thinking, behavioural finance delves into the intricacies of human behaviour and psychology
when it comes to money matters. This intriguing field explores how individuals' emotions,
biases, and cognitive errors influence their financial choices, shedding light on why people
sometimes make less-than-optimal decisions despite knowing better.
So overall we have studied traditional and behavioural finance. In the realm of finance, two
prominent schools of thought have emerged: traditional finance and behavioural finance.
While traditional finance focuses on rational decision-making and efficient markets,
behavioural finance explores the impact of psychology and human behaviour on financial
decisions and market outcomes. Delving into the contrasting perspectives and theories within
these two fields can shed light on the complexities of the financial world and provide
valuable insights for investors and policymakers alike. So now it is crystal clear what is
Traditional Finance and Behavioural Finance.
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Difference Between Traditional Finance and Behavioural Finance
TRADITIONAL FINANCE BEHAVIOURAL FINANCE
Investor Describes how investors should Tries to explain how investors
Behaviour Behave. behave.
Information Investors have perfect information Investors have limited
and process information in an information and try to make
unbiased manner. decisions that satisfy (satisfy +
Suffice, bounded rationality)
They also exhibit cognitive and
emotional biases while making
these decisions.
Attitude to Risk Investors are risk-averse. They will Investors are not consistently
reject all gambles with non-positive risk-averse. They do take
expected returns. gambles with non-positive
expected returns.
Utility Based on ‘Expected Utility Based on ‘Prospect Theory’.
Theory’.
Markets Assume markets are efficient. Assumes the market is not
entirely efficient. Supports
‘Adaptive market Hypothesis’.
Portfolios Investors create mean portfolios– Investors create portfolios that
variance optimized. are layered to satisfy their goals.
Behavioural Finance is based on the psychology of investors and their attitudes and
behaviour towards the company and people after making investment decisions on the other
hand Traditional Finance is wholly based on all mathematical calculations and economic
models.
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Let us now know some main key differences between Traditional Finance and
Behavioural Finance:
• Traditional Finance assumes that investors are rational and make decisions based on
all available information. On the other hand, behavioural finance recognizes that
investors are humans and make decisions influenced by their emotions, biases, and
cognitive limitations.
• Traditional Finance assumes that the financial markets are efficient and that prices
reflect all the information. On the other hand, behavioural finance believes that the
financial market is not always efficient and that there are opportunities for investors to
profit from market anomalies.
• Traditional Finance is normative, meaning that it provides guidelines on how
investors should make decisions. Behavioural Finance is descriptive, meaning that it
describes how all investors make decisions.
In recent years, there has been growing interest in behavioural finance to better
understand how investors make decisions. This has led to the development of new
investment strategies incorporating behavioural rights.
Commonalities between Traditional Finance and Behavioural Finance:
The commonalities between traditional finance and behavioural finance are:
• Both theories are concerned with the study of financial markets and investment
decisions.
• Both theories use mathematical models and statistical analysis to understand
financial markets.
• Both theories believe that investors are motivated by self-interest and try to
maximize profits.
• Both recognize that the financial markets are complex and unpredictable.
So there were few commonalities between Traditional Finance and Behavioural
Finance. In the next slide, we will understand some of the similarities between
Traditional Finance and Behavioural Finance.
Let us first understand the Impact of Behavioural Finance on Traditional Finance
models:
Traditional Financial models have been significantly impacted by Behavioural
Finance. The following are a few ways that behavioural finance has altered
conventional finance models.
➢ Question the idea of marketing efficiency: Market efficiency, or the idea
that prices accurately represent all available information, is a fundamental
tenet of conventional financial models. Markets are not always efficient,
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though, as behavioural finance has demonstrated, and there are times when
investors might profit from market abnormalities.
➢ Demonstrated the effects of investor prejudice: Traditional Financial
models assume that investors are logical and base their judgments on all
available data. This may cause investors to make irrational investment choices
that differ from what conventional financial models would suggest.
➢ Enhanced financial product design: The design of financial products,
including insurance policies, retirement plans, and mutual funds, has been
enhanced using behavioural finance techniques.
Similarities between Traditional Finance and Behavioural Finance:
Here are some concrete instances of how standard financial models have been enhanced by
behavioural finance:
➢ Prospect Theory: A behavioural economics theory known as “prospect theory”
explains how people make decisions when they face risk. It has been applied to
enhance the measurement of financial risk and create financial solutions that are more
likely to appeal to customers.
➢ Mental Accounting: It is a cognitive bias that describes how people arrange their
finances in their minds. It has been employed to justify why individuals choose
various investing strategies for various sorts of assets, such as their retirement savings
and their home equity.
➢ Herding: The propensity of investors to follow the herd is referred to as a behavioural
phenomenon called herding. It has been used to illustrate how investors' psychology
may occasionally cause stock values to become overvalued and undervalued.
These are only a few instances of how standard financial models have been enhanced by
behavioural finance. The influence of behavioural finance on our understanding and
management of money is anticipated to grow as the field matures.
So, with this report, I have explained and described all the differences between traditional
finance and behavioural finance and the similarities between traditional finance and
behavioural finance.
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