Differences between traditional finance and

behavioral finance

Submitted by: Crizmy Arellano Dalisay

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 Table of Content

Title Page…………………………………………………………………………… 1

Acknowledgement…………………………………………………………….......... 2

Table of Content……………………………………………………………………. 3

Abstract…………………………………………………………………………… . 4

Executive Summary………………………………………………………………… 5

Introduction…………………………………………………………………………..6

Overview of situation………………………………………………………………. 7

Analysis/issues to solved……………………………………………………………..8

Recommendation……………………………………………………………………..9

Conclusion……………………………………………………………………………10

Reference……………………………………………………………………………..10
 Abstract

Behavioral finance is more concerned with examining a person's regular pattern of financial

decisions, whereas traditional finance is more rational, focusing on complex equations, economic

models, and market activity. This article investigates individual investment choices and addresses

the various behavioral finance aspects that influence investment in developing nations such as

Pakistan. The introduction simply discusses the differences between traditional and behavioral

finance literature, which comprises of several behavioral finance and traditional finance

components.
 Executive Summary

In this research we are going to examine the distinction between traditional finance and behavioral

finance in this post. Before we begin, let's define the terms traditional finance and behavioral

finance. What exactly is traditional finance? Traditional finance is finance that has been practiced

for a long time using the customary or traditional mode of financing, which includes obtaining a

loan or a line of credit from financial institutions, notably banking organizations. Investors' actions

in traditional finance are rational, and it operates in an environment of uncertainty and risk. It is

concerned with a wide range of concepts, theories, and principles. Traditional finance is said to be

normative since it adheres to commonly accepted rules and expectations. Traditional finance is

believed to be objective because it is not influenced by human feelings or opinions and is entirely

focused on facts.

What exactly is behavioral finance? The term "behavioral finance" implies that it is concerned

with a person's style of functioning or the psychology of the person behind an idea. In a nutshell,

behavioral finance is the study of investors' psychology when investing or making financial

decisions. Investor decisions in behavioral finance are based on emotional biases such as

overconfidence, regret, fear of loss, self-control, and so on. It is also said to be subjective because

the decisions are influenced by any personal feelings or opinions and are based on a single point

of view. Behavioral finance decisions are descriptive, as opposed to standard finance decisions.

As a result, the main distinction between traditional finance and behavioral finance is that one is

based on reason and the other on the investor's psychology, respectively.

Decision making is a critical activity in the process of selecting an alternate option from a

circumstance that produces positive consequences for individuals or investors. The goal of

investing is to make money for the investors. Individual market participants and information

structure have an impact on investing decisions. As a result, investment can occasionally provide

negative effects for investors who invested for a specific reason or who are dissatisfied with the

results of their investment owing to investor behavior. According to Buchan (2001), "money is

desire embodied." According to Kahneman and Tversky (1979) and Statman (1999), people

experience pain when they learn that the other option produces positive benefits. So behavioral

finance is the research that describes to investors who seek in discovering how individual emotions

or behavior are related to share price movements.

Behavioral finance explores how and why emotions and cognitive biases cause stock market

oddities for investors. However, in modern finance, we take the concept of rationality and logical

theory-based decisions such as the Capital Asset Pricing Model and efficient market theory, which

assume that people are rational and work to maximize their wealth, but the reality is that people

behave irrationally in real life, and this irrationality is linked to behavioral finance. Behavioral

finance describes our actions and behaviors, whereas modern finance is concerned with explaining

the activities of an economic man. Traditional finance is concerned with decisions in which

complete information is accessible for making investment decisions.

Becker (1962) and Thaler (1990) mentioned in the function of Behavioral Economics and

Behavioral Decision Making in Americans Retirement Saving Decisions that Forced to watch the

full information according to the Traditional theory; they can also share the information and
rational decision makers. These people's properties remained consistent and well-defined over

time. According to Phung (2010), behavioral finance is a relatively new topic that develops the

merger of psychological theory, cognitive and behavioral with finance and traditional economics

to deliver the conclusion about people's illogical decision making. Behavioral finance theory was

created in 1980 by a small group of academics from several fields.

Overview of situation

The field of investor behavior seeks to comprehend and explain investor actions by merging the

topics of psychology and investing on a micro level (i.e., the decision-making process of people

and groups) and a macro level (the decision-making process of individuals and groups) (i.e., the

role of financial markets). Investors' decision-making process includes both a quantitative

(objective) and qualitative (subjective) component based on the unique qualities of the investment

product or financial service. Investor behavior investigates the cognitive (mental processes) and

affective (emotional) difficulties revealed by individuals, financial professionals, and traders

during the financial planning and investment management processes. In practice, people make

decisions and make judgements based on prior occurrences, personal beliefs, and preferences.
 Analysis/issues to solved

In behavioral finance, a self-serving bias is a tendency to credit positive results to human abilities

and unfavorable outcomes to pure luck. To put it another way, we pick how to credit the source of

a result based on what makes ourselves appear the best. Certainly, most of us can think of things

we've done and establish that when everything goes as planned, it's certainly attributable to our

ability. Then, when things don't go as planned, it's obvious that we've merely experienced poor

luck.

The traditional finance business is undergoing a major transformation as a result of new,

progressive banking and finance views. Many traditional banks have been left behind as a result

of increased competition from FinTech and experience-driven banking. Today's rapidly changing

financial world demonstrates the rapid evolution of banking's primary "utility value."

Recommendation

It is critical to recognize when we have followed incorrect reasoning that has resulted in a negative

outcome. Only by admitting and evaluating our mistakes will we be able to learn from them. And

it's only through identifying when we've succumbed to thinking traps like the self-serving bias that

we can learn to avoid them in the future. Consider keeping an investment/trading journal.

Reviewing a well-kept trading notebook will help you easily discover your trade's strengths and

limitations. It can also assist you in identifying – and so correcting – faults that you make on a
regular basis. On the plus side, it can assist you in determining when and why your analysis was

accurate. You may also see things that you would not have noticed otherwise. For example, some

traders discover that the bulk of their profitable deals are initiated at a specific time of day or on a

specific day of the week for whatever reason.

Conclusion

There are two schools of thinking in financial matters: traditional financial theory and behavioral

finance. Traditional finance theory implies that people make decisions by obtaining all relevant

data and have the abilities to analyses this information rationally and unemotionally in order to

make the best option. Traditional assumptions are challenged by behavioral finance, which

analyzes the psychological elements influencing financial behavior. Students in this subject think

that humans make judgments based on insufficient knowledge and, for the most part, lack the

ability to use that information to make the best decision. Furthermore, they contend that emotions

and prejudices distort cognition, causing humans to act irrationally and predictably, resulting in

poor conclusions. The behaviorists appear to be supported by real-life experience. When it comes

to spending, saving, and investing money, people in otherwise identical personal and financial

circumstances might behave extremely differently. Traditional finance, in addition to being logical

and calculated, believes that people have and exercise the self-control to make financial decisions

that are in their long-term best interests. Instead, psychologists have discovered that self-control

varies greatly amongst individuals and that many are influenced by social and psychological
circumstances that cause them to engage in conduct that is detrimental to their most important

goals. Investing in anything from properties, gold, stocks or an essay writing website is a bold and

risky move. But what most people don't know is that the decision to invest in those stocks is

influenced by traditional and behavioral finance.

References
https://www.researchgate.net/publication/268747412_Impact_of_Behavioral_Finance_Tradition
al_Finance_on_Financial_Decision_Process
https://www.lowellsun.com/2019/08/04/traditional-financial-theory-behavioral-finance/
https://dstreetanalyser.com/2021/10/26/traditional-finance-behavioural-finance/
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/-bias/