In this article, let us learn the difference between traditional finance and behavioural finance. Before anything else, let’s get acquainted with the terms traditional finance and behavioural finance.
What is traditional finance? Traditional finance is the finance which is carried out from a very long period of time following the usual or traditional method of financing which includes getting a loan or a line of credit through financial institutions, specifically, banking institutions. For example, a person getting a loan from a bank is considered as traditional finance. In traditional finance, the decisions taken by investors are rational and it operates under the condition of uncertainty and risk. It is concerned with numerous concepts, theories and principals. Traditional finance is said to be normative as it follows the rules and expectations which are followed universally. It is not influenced by any personal feeling or opinion and is solely based on facts hence traditional finance is said to be objective.
“I’ve learned there is a big difference between a long-focused value investor and a good short-seller. That difference is psychological and it falls into the realm of behavioural finance”. – James Chanos.
What is behavioural finance? The word behaviour itself suggest that behavioural finance is about a person’s way of acting or the psychology of the person behind a concept. In short, behavioural finance is the study of the psychology of the investors while investing or making investment decisions. For example, an investor analyses any share, the profit and loss of the company, the environment of the firm, thousands of times before investing in it. This thinking procedure of the investor is assumed as behavioural finance. Therefore, in behavioural finance the investors decisions are based on emotional biases which includes overconfidence, regret, fear of loss, self-control, etc. It is also said to be subjective as the decisions are affected by any personal feeling or opinion and is based on only one perspective. Unlike in traditional finance, the decisions taken in behavioural finance are descriptive.
Therefore, the main point that help us tell apart traditional finance and behavioural finance is, one is based on rationality and the other is on psychology of the investor, respectively.
I’m a BFM first year student eager to learn more about finance and stock market. I love reading horror and friction books.