Behavioral finance theories towards traditional finance theories Literature review
Author | Blerina Dervishaj |
Position | University of Vlora 'Ismail Qemali |
Pages | 44-58 |
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 fi nance theories towards traditional fi 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
fi nance how fi nancial markets should function and how investors should behave in an ideal
world, whereas for behavioral fi nance theories, how fi 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 infl uence
of the human psychological factor on fi nancial decision-making and market events.
The infl 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
fi eld of fi nance have had an enthusiastic approach in using mathematical models as
well as a consistent tendency to mathematize the study of fi nancial behavior.
Over the last 60 years, traditional fi nance theories have shown that investors are
rational, well-informed, fi rmed, and not a ected by emotions they when make
fi 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 fi eld
in Finance: Financial Behavior, a multidisciplinary research fi eld which studies
investor’s psychology during fi nancial decision-making process and also integrates
psychology with fi nance. Behavioral Finance studies the factors that infl uence the
fi nancial decision-making process of investors, and explains their irrational nature. It
tries to explain investor’s decisions by combining psychology and fi 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 fi 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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