Traditional and Behavioral Finance

Abstract

The purpose of this chapter is to compare and contrast traditional and behavioral finance. In traditional finance, which has been the dominant paradigm for several decades, investors make rational choices leading to maximizing expected utility. The fundamental issues of traditional finance are classical decision theory, rationality, risk aversion, model portfolio theory (MPT), the capital asset pricing model (CAPM), and the efficient market hypothesis (EMH). However, evidence shows that many of the assumptions and findings associated with traditional finance are invalid. Thus, behavioral finance researchers turned to observed behaviors to develop models that describe how investors actually reach their decisions. Behavioral finance uses insights from the social sciences to better understand the investor behavior of individuals, groups, and markets. Among the foundation topics in behavioral finance are behavioral decision theory, bounded rationality, prospect theory, framing, heuristics, overconfidence, regret theory, and mental accounting. The emerging areas of research are behavioral portfolio theory, the behavioral asset pricing model, and the adaptive markets hypothesis.