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HARSH DESAI

FE-08318

INVESTMENT BANKING

05 OCTOBER 2023

Difference and Similarity between Behavioural Finance and Traditional Finance

Introduction to Traditional Finance and Behavioural Finance

Traditional Finance and Behavioural Finance are two varied approaches in

understanding the financial market dynamics and investor behaviour. Traditional Finance

assumes that the investors are rational and can process all information unbiased. They simply

gather or receive all the information they have and the data that support their decisions.

Therefore, traditional finance states that the investors don’t make financial decisions based on

emotions.

Behavioural Finance acknowledges that the investors can be influenced by emotions

and cognitive biases. By studying the psychological behaviour of an individual, behavioural

finance provides a more comprehensive understanding of the financial markets and offers

insights into the market anomalies and bubbles. In Behavioural Finance, investors might base

their decisions on fear, overconfidence, gut feeling, what others do thereby following the

gang and past experiences. In Behavioural Finance they basically have a heuristic biasness

where they interpret what others do and try to implement the same work what others have

done.
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Traditional Finance is an extension of “Traditional Economics” which delves into the

traditional data points by using mathematical calculations, economic models and checking the

market behaviour.

Behavioural Finance is an extension of “Behavioural Economics” which focuses on

understanding the individuals/group emotions and judgement made to predict the growth of
an economy and decisions. It’s a concept that is adopted from the field of advanced
psychology known as Mental Mapping.

Distinct Differences between Traditional Finance and Behavioural Finance

While both Traditional Finance and Behavioural Finance have contrasting views of

the financial and investing world. Here are the main differences between Traditional Finance

and Behavioural Finance.

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1. Traditional Finance assumes that the investor is rational and provides an unbiased

opinion which can process all unbiased information. While Behavioural Finance draws from

real world experiences and is based on the assumptions that investors have biases, its

irrational and emotions play an integral part in the modern investments undertaken. For

instance, a retail investor who doesn’t have enough knowledge about the stock gets a tip from

a trader or a professional investor to buy that stock, the retail investor would prefer to go for

it as emotions play a big role in buying that stock and heuristics biases play an integral role of

fear of missing out on that stock.

2. In Traditional Finance, investors receive unlimited knowledge and data that are

perfect. The investor carefully processes this information which leads to complete rationality.

While in Behavioural Finance, investors have bounded rationality accordingly the investors

don’t process all the information. Regardless of how accurate the knowledge is, investors are

still sure to make a mistake in their judgment.

3. Traditional Finance focuses on understanding the “what” of investor decisions such

as asset selection or risk acceptance. On the other hand, Behavioural Finance focuses on the

underlying behavioural and psychological elements that influence investor decision making

including social factors, psychological biases, cognitive biases and emotions.

4. Traditional Finance does not consider market interactions and focusses on the

individual investor’s rationality. On the other hand, Behavioural Finance acknowledges

market sentiments and emotions play a critical role in determining investment decisions.
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5. Behavioural Finance is a similar tool used by weather forecasters, economic

forecasters which deal with complex system as it is used to predict the human being thinking

to their financial decisions. On the other hand, Traditional Finance is based on various

theories, assumptions and models build to take decisions.

6. Traditional Finance states that the market is efficient, and the market represents the

financial market’s actual value. Traditional finance believes that there are no market

inefficiencies and the market’s actual value is computed bases on the mathematical

calculations and the different market data. On the other hand, Behavioural Finance believes

that the market is volatile and that there is market anomalies. The volatility of the market

results in rising and falling of stock prices in the market which proves the inconsistences in

the market.

7. Traditional Finance follows a normative approach which means following as per

the market guidelines without being emotionally biases towards the market. On the other

hand, Behavioural Finance follows a descriptive approach which means describing how

investors make decisions.

To conclude the main difference between Traditional and Behavioural Finance, both

play an important role on the finance impression of the investors and the financial decisions

on the investment.
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Similarities between Traditional Finance and Behavioural Finance

1. The Similarities between the Traditional Finance and Behavioural Finance are as

follows-

2. Both the theories are concerned with the study of financial markets and investment

decisions.

3. Both the theories use mathematical models and statistical analysis to understand the

financial markets.

4. Both the theories believe that the investors have a different approach with respect

to investment approaches.

5. Both the theories recognise that the financial markets are complex and

unpredictable.

The below chart represents the commonalities between Traditional and Behavioural Finance.

Source- Research Gate

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Works Cited

https://www.equitypandit.com/difference-between-traditional-finance-and-behavioural-

finance/

https://www.linkedin.com/pulse/differences-similarities-between-traditional-finance-

behavioral/

https://medium.com/@zeeshaan2696/behavioral-finance-v-s-traditional-finance-

e0b32ed25901