Essay on why rationality is one of the assumptions of modern finance
As observed by Shleifer (2000) ‘At the most general level, behavioural finance is the study of human fallibility in competitive markets.’ Behavioural finance incorporates elements of cognitive psychology into finance in an effort to better understand how individuals and entire markets respond to different circumstances. Behavioural finance is based on the principle that all investors are not rational. Some investors can be over-confident, while other less knowledgeable investors might be prone to herding effects. Shefrin (1999) was one such author to talk about behavioural finance. He is one author who argues that ‘a few psychological phenomena pervade the entire landscape of finance.’ Harrington (2003) agrees with the notion that overconfidence can lead to irrational behaviour. She states that ‘investors can become irrational and their irrational behaviour affects their ability to profit from owning stocks and bonds.’
Of course, behavioural finance does have its drawbacks. One of which is the fact that using instincts alone can result in a loss. This is due to human error. The person that is using their instincts in determining where to invest might not have the greatest financial knowledge in the first place. Also, this person might be having a bad day or be under a great deal of stress or be distracted in some other way. This could result in the wrong decision being made. Therefore, it is a good idea to use behavioural finance on top of the more traditional theories already in use today.
This view is supported by an article by Malkiel (1989) who agrees with the notion that behavioural aspects have a great importance in stock market valuation. He argues that behavioural factors play an important role in stock valuation alongside traditional valuation theories. This is summed up by the following quote, ‘market valuations rest on both logical and psychological factors.…
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Tags: assumptions, behavioural finance, modern finance, rationality
