Behavioural finance - The Irrational Influences

From the mid-1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the University of Chicago. The central assumption of the traditional finance model is that people are rational.

However, psychologists challenged this assumption. They argued that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.

The finance field was reluctant to accept the view of psychologists who proposed the behavioural finance model. As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioural finance has received greater acceptance.

Although there is diagreement about when, how, and why psychology influences investment decisions, the award of 2002 Nobel Prize in Economics to psychologist Daniel Kahneman and experimental economist Vernon Smith is seen by many as a vindication of the field of behavioural finance.

Key differences

The key differences between "traditional finance" and "behavioural finance" are as follows:

1. Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their beliefs and predisposes them to commit errors.

2. Traditional finance presupposes that people view all decisions throgh the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influence by how decision problems are framed. In other words, behavioural finance assumes frame dependence.

3. Traditional finance assumes that people are guided by reason and logic and independent judgment. Behavioural finance, on the other hand, recognises that emotions and herd instincts play an important role in influencing decisions.

4. Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects of emotions and social influence often lead to discrepancy between market price and fundamental value, thus market inefficiencies.