Traditional vs Behavioral Finance
The Difference Between Traditional and Behavioral Finance
What is Traditional Finance?
Traditional finance aims to make money from the debt instruments on which it trades. There are two main types of debt instruments: Treasury bills and bonds. Treasury bills are bills that are given to investors and typically pay a fixed rate of interest for a certain period of time. Bonds are another type of debt instrument that are issued by governments and usually have fixed interest rates for a specific period of time. In return for issuing these instruments, government's promise to repay the bondholders with interest. A traditional finance analyst will usually buy and sell a debt instrument based on the fundamentals of the company it represents. The investor will look at the fundamentals to determine if the bond is a good investment.
What is Behavioural Finance?
Behavioural finance is a relatively new discipline and has become one of the most popular areas of economics in recent years. It focuses on how human beings make investment decisions. People do not always act rationally. They also pay far more attention to the information they choose to than would be considered rational. This can lead to the false assumption that people act in a rational way and drive asset prices far higher than they are likely to be able to sustain.
There are several factors that make it necessary to study this field of economics. The first of these is the fact that human beings have a tendency to overreact. If there is a good news story about a company that had gone bust, for example, the media and other investors can quickly turn to it as a reason for a new rally in
The Differences Between Traditional and Behavioural Finance
If we want to make the best investment decisions we need to understand both the traditional and the behavioural forms of finance. Understanding each form of finance helps us to make better-informed investment decisions. The differences between the two forms of finance are outlined below: Traditional Finance focuses on making money from the market. Investors make investment decisions based on their financial goals. They invest in assets that represent the profit from these goals. Traditional finance sees assets as assets and does not see them as the risk they represent. Traditional finance does not change over time. It is a static market. Behavioural Finance Behavioural finance is a form of economics that studies the way we make decisions.
The Importance of Both in Investing
While behavioural finance might not be as useful for individual investors, it is still very useful for corporations and organisations such as hedge funds. For example, if an organization knows that their employees can’t resist the siren song of taking a holiday, they can hedge against it. If a company knows that they will lose customers if there is a charge for charging for excess baggage on flights, they can avoid the expense. Also, if a company knows that there is a high demand for travel insurance, they can increase prices knowing that they will get higher demand. Predicting the Future Behavioural finance is more useful for forecasting the future because you can understand the biases and psychological factors that influence our investment choices.
There is no perfect time to invest and there is no magic formula that guarantees success. People should invest for the long term and not be in it for short-term gains. The size of an investment will be a major factor for success. If you have limited funds, it will be hard to be consistent in your investments. Risk comes in different forms. On the one hand, investing in a diversified portfolio of low-cost index funds is risk-free but this may also mean less return. Investors who have more time on their hands and fewer assets to invest will be better off if they buy individual stocks, although this is risky as they may have high cash flow needs.
Written by Ishmita Vaish