Behavioral finance theories towards traditional finance theories Literature review

AuthorBlerina Dervishaj
PositionUniversity of Vlora 'Ismail Qemali
Pages44-58
Vol. 2 No. 2
June, 2018
European Journal of Economics, Law and Social Sciences
IIPCCL Publishing, Graz-Austria
ISSN 2519-1284
Acces online at www.iipccl.org
44
Behavioral nance theories towards traditional nance theories
Literature review
MSc. Blerina Dervishaj
University of Vlora "Ismail Qemali
Abstract
Traditional Finance and Behavioral Finance try to explain investor’s behavior with di erent
arguments and theories. The simplest way to think, is to think about theories of traditional
nance how nancial markets should function and how investors should behave in an ideal
world, whereas for behavioral nance theories, how nancial markets function and how
investors actually behave in the real world. Understanding both theory and reality, helps
investors in making be er investment decisions. This paper aims to summarize the main
theories of Traditional Finance and Financial Behavior based on the existing literature for the
two schools of thought.
Keywords: Traditional Finance, Behavioral Finance, Theories, Investing Decision.
Introduction
Over the years, researchers have been trying to understand how human behavior
and the way its brain works a ects decision-making. They recognize the in uence
of the human psychological factor on nancial decision-making and market events.
The in uence of Psychology in Finance has been studied by Keynes since the 1920s,
who emphasizes that uncertainty makes people’s future decisions, not only depend
on their mathematical expectations, but also on other important factors for decision-
making such as caprices, a itudes, or even just luck. Traditionally, academics in the
eld of nance have had an enthusiastic approach in using mathematical models as
well as a consistent tendency to mathematize the study of nancial behavior.
Over the last 60 years, traditional nance theories have shown that investors are
rational, well-informed, rmed, and not a ected by emotions they when make
nancial decisions. Based on surveys, the reality is that they rarely behave according
to the above assumptions. Recent developments in Finance have focused more and
more on the human aspect of the investor in the decision-making process. This idea
was strongly supported by academic and professional circles generating a new eld
in Finance: Financial Behavior, a multidisciplinary research eld which studies
investor’s psychology during nancial decision-making process and also integrates
psychology with nance. Behavioral Finance studies the factors that in uence the
nancial decision-making process of investors, and explains their irrational nature. It
tries to explain investor’s decisions by combining psychology and nance knowledge
in both micro and macro level (Investor Behavior, 19, p. 7). In 2002, Daniel Kahneman,
a researcher in the Behavioral Economics, was awarded with the Nobel Prize in
Economics (Michael M. Pompian and John M. Longo, 2004). The most famous and
classic theories in nance such as E ciency Markets, Modern Portfolio Theory, CAPM
Model, the theory of Expected Utilities, assume that the investor is rational, elaborates

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