This section is exclusively dedicated to Behavioural Finance.
One of the most important tenet on which the traditional finance paradigm relies is the “Homo Economicus” assumption.
The latter states that individuals are fully rational… but what does that imply? It implies that these finance participants (wealth maximizers and risk minimizers) not only make perfectly unbiased decisions, but also possess unlimited processing powers on all available information thereby giving them the ability to hold a portfolio of investments suiting their level of risk aversion, of course after having assessed all risk-return options.
This sounds all too good on paper… However, throughout the years, many empirical findings have told a different story, which such a framework fails to explain. The truth appears to be that, contrary to the “Homo Economicus” we all believed we were, a more realistic one seems to be the “Homo mainly Economicus but occasionally Mistakus”.
In fact, it appears that people deviate from the “full rationality” assumption, thereby making mistakes in the update of beliefs and consult of their preferences, resulting in biases [see the Behavioural Finance ABC].
This is where Behavioral Finance comes into play! It refers to the study of psychology’s influence on financial practitioners’ behavior and the effect on markets that follows.
One could even say that Behavioral Finance acknowledges the function John Maynard Keynes’ animal spirits have in justifying the choices of investors.
However, a simpler way of describing this concept can be found in the words of one of the main representatives of this field, Richard Thaler, who, at an NBER conference, addressing Robert Barro, a supporter of the traditional doctrine, stated:
“the difference between us is that you assume people are as smart as you are, while I assume people are as dumb as I am”.
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