The etymology of finance can be traced to 3000 BC, during the early days of civilization and it originated in Babylon where their Temples and palaces were used to store valuable and priceless jewelleries which was also known as a bank to them. At first, the only valuables that could be deposited were grains but subsequently, cattle and important materials were also included.
According to the Webster dictionary, finance is defined as the way in which money is used and handled, especially the way in which large amounts of money are used and handled by governments, companies or individuals.
Webster dictionary further went to define finance as matters which are related to money and how it is spent or saved.
- Farrell and Geoffrey Hirt defined finance as “all activities related to obtaining money and effective use” while Wikipedia defined finance as “the art and science of managing money.”
In all of the definitions above, there is one thing that is synonymous with all the definitions and that is “money.” In other words, money is the bedrock of the word “finance”.
In every part of the world, the financial stability of the country plays a pivotal role in the decline or promotion of the country’s economy. just as Simon Andrade defined finance. According to Andrade, “finance is the area of economic activity in which money is the basis of the various embodiments, whether stock market investments, real estate, industrial, construction, agricultural, developments and many others.
To keep the definitions short and 1simple, finance is the overall system that allows the flow of money through investments and other financial certifications either between or within these sectors mentioned above.
In every sector or research platforms, there will always be different schools of thought and for the financial sector, two schools of thought exist which are the traditional finance theory and the behavioral finance theory. For the purpose of this article, we would be looking at their differences.
Traditional theory is based on the fact that investors act with the ability to think or reason about things clearly and that they are repugnance when it comes to risk taking. This simply means that the investors are aware of the data they have gathered and they have the skills to process the pieces of information which will enable them to arrive at the right choice. they don’t act irrational in making decisions.
The students from this school of thought are of the knowledge that investors dislike risk taking and that every investor is supposed to gather facts and collect data that will be effective in their finance instead of acting on their impulse and emotions. In this school of thought, investors are meant to be logical and calculating and that they are meant to possess self-control and exercise patience in order to make the right call that will be in their best interest for a long time.
to further understand the traditional finance theory, this is what the school of thought is about in a simple form;
- the market and investors are rational
- they are not confused by forced errors or information processing errors
- investors are truly concerned about a utility personality.
- The self-control of the investors is high.
Behavioral finance can be seen as the psychological study of investors and the effects of the financial markets. Students of this school of thought believe that people make decisions based on assumption which may be due to lack of information or incomplete data collection which makes them lack the ability to convert the information or data to their best interest.
In furtherance, the students are of the notion that emotions fudges reasoning which leads people to act;
- Investors are influenced by their own facts and data collection
- Investors are treated as “humans” who are above mistakes and not “rational”.
- Investors make sensitive errors that can lead to wrong decisions.
- They have limits to their self control.
Psychologists have also shown that self control differs widely from individuals and that many people are socially and psychologically influenced which leads them to destructive behaviors and make them forget their most important goals.
to simply understand the behavioral theory, here is a breakdown.
In the behavioral school of thought, the students see investors as “humans” who are not above mistakes and will always fall into the trap of making mistakes. according to the students of this school of thought, these are some of the reasons why an investor can make the wrong decision;
The school of thought believes that an investor makes the wrong call sometimes due to the emotional state of the investor at the time which may be irrational. They believe that our current mood can steal our decision making from us and leaves us with a clueless and unforgivable decision to make. In this school of thought, emotions refers to the decisions we make or take in our current mood.
- Social Influence
In this situation, people are said to be responsible for the choices you made. The behavioral finance theory believes that the society or people around you can influence your choice negatively which in turn can lead to a downturn in your investment or perhaps, crash it.
In this error, the investor believes that they know what they are doing and that the decision they are making is the right one. To them, it is a decision that will give them a better and lasting investment but oftentimes, in such a situation, the investor focuses more on his beliefs and decisions that they miss the important details.
- Learning From Experience Simplification
This is also called heuristic simplification in behavioral theory and it has to do with information-processing errors.
Behavioral finance theory seeks an understanding of the impact of personal biases on investors and as such we would be looking at the list of common financial biases by the students of this school of thought;
- Framing Bias
This situation happens when decisions are made based on how the information was presented as opposed to just on the facts themselves. For example, when two people present the same facts in two different ways can lead to people making different judgements or decisions. In behavioral finance theory, investors may react to a specific opportunity differently and this will depend on how the data was presented.
how an investment is framed can cause investors to change their minds on the conclusions they’ve made about the good nature of the investment or not and when investors are not sure of the concrete facts about the investment, there is a high possibility of reflexive decision making.
- Loss Aversion
This is a tendency in this school of thought where investors are scared of losses that they focus on reducing the possibility of a loss more than focusing on the profits. A data carried out on loss inversion shows losses hurt investors twice as strongly as they feel the excitement that comes with profits.
- The Narrative Fallacy
narrative fallacy is the ability to evaluate information objectively. Everyone loves stories and sometimes we let our preference for good stories cloud the facts and our ability to make rational decisions. This means that we may be drawn into a less desirable outcome simply because it has a better story.
- Anchoring Bias
This often happens when people depend too much on pre-existing information or the first information they find during decision making. Let’s take this scenario as an example. you went to get a pair of shoes and you saw the first one which cost $300 and then you walked a little further and saw another one that was sold for $100, you’d obviously see the second one as cheap. but if you get to see the first one at the price of the second one and vice versa, you’d probably see the first one now as cheap. the anchor is the first one you saw which obviously influenced your opinion.
- Overconfidence Bias
This is a tendency that helps us hold a false and misleading assessment of how smart and skillful we are. In fact, it is a boastful belief that we are better than we are. it can be dangerous and very prolific in the behavioral finance and capital markets.
Understanding the movement of the markets and where they are going is one of the most important skills in finance and investing. In this industry, most market analysts consider themselves to be above average in their analytical skills. However, it is obviously a statistical impossibility for most analysts to be above the average analyst.
- Herding Mentality
This refers to the investors’ tendency to follow the footsteps of what the other investors are doing. The investors are hugely influenced by emotion and instinct, rather than by their own significant analysis.
- Self Serving Bias
This is a tendency to attribute good outcomes to our skill and bad outcomes to bad luck. Simply put, we choose to attribute an outcome based on how best we want to make it look. When it turns out beautifully, we want to attribute the outcome to our smartness and skill but if the outcome is bad, we just attribute it to bad luck or sometimes, someone’s lack of skill.
- Representative Heuristic Bias
This happens when the similarity of objects or events confuses people’s thought, distinguishing the possibility of the outcome. Oftentimes, people make the mistake of believing that two similar things are more closely connected than they actually are.
- Confirmation Bias.
This happens when people pay attention to information that confirms their belief and ignore information that is contrary to what they believe. Our biases often limit us to make purely rational investment decisions.
- Hindsight Bias
This is the misconception after the fact that one always knew that they were right.
We have seen so much about the Behavioral Finance so let us take a look at the differences between traditional finance theory and behavioral finance theory;
- According to traditional finances, investors receive unlimited knowledge, data, and information that are perfect but in behavioral finance, the investors have bounded rationality so the investor doesn’t process all information.
- Traditional finance assumes that an investor is a rational person who can process all information unbiased while behavioral finance draws from real-world experience stating that an investor has biases and his emotions do play a role in the kind of investments taken.
- Traditional finance states that the market is efficient and it is a representation of the financial market’s true value while behavioral finance believes that the market is volatile and that’s why there are market anomalies.
- In traditional finance, the investors level of self control is on a high because they take their time to gather information that will lead them to a long lasting profit while in Behavioral finance, the investors have a limited level of self control because they don’t wait to gather concrete information but rather they act on impulse and emotions which sometimes leads them to drastic decision making that usually doesn’t end well.
The Traditional finance theory and the behavioral finance theory both make a wide range of assumptions about making decisions when it comes to investments. If you understand financial psychology, it will help you to understand the flaws that traditional finance possesses. without you being aware of it, a wide range of biases can affect your decision making.
The best way to reduce the effectiveness of financial bias on decision making is to assume that you have these thoughts but secondly, you can also use the knowledge to your advantage.
The traditional finance theory and modern finance theory are essential in the financial sector. They help to guide investors on their next investment, especially the behavioral finance theory which shows us the psychological aspect of finances and also helps investors. In conclusion, the behavioral finance school of thought is a better version of the traditional finance school of thought.