Behavioral Finance vs.

Traditional Finance Theory

Behavioral finance can be studied from both the micro and macro levels of the economy and capital
markets. Behavioral finance micro (BMFI) focuses on the behaviors of individual investors, whereas
behavioral finance macro (BMFA) focuses on the behavior of the markets, questioning ideas of
market efficiency. Behavioral finance challenges the idea that investors are rational at both the micro
and macro levels.
Behavioral biases can be either emotional biases or cognitive errors. While emotional
biases stem from feelings, intuition, or impulsive thinking, cognitive errors stem from
misunderstanding data, faulty reasoning, statistical miscalculations, or memory errors. Both types of
biases can lead to poor investment decisions that are not rational. BFMI suggests that these
biases impact an individuals economic decisions, and BFMA asserts that markets are subject to the
effects of these collective decisions.
BMFI and BMFA differ from traditional finance theory, which assumes normative principles to model
how the markets should act. In traditional finance theory, investors are supposed to act
rationally (which most investors certainly do not!). Theyre assumed to have access to perfect
information, process that information without bias or emotion, act in a self-interested manner, and be
risk-averse.
Traditional theory assumes investors make economic decisions using utility theory, where they
maximize the net present value (NPV) of utility, or the benefit they receive from an action, subject to
a constraint. This benefit can also be characterized as satisfaction resulting from the consumption of
good and services.
Unfortunately, most investors do not make decisions in a vacuum of perfect information
and process that information without bias in or emotion. Neither do they maximize the
net present value of the future benefits of their choices and actions by making decisions
in their own best interests with their capital. Most investors do not see the ramifications
of their daily actions, let alone the results of their actions months and years in the
future.
Expected utility is the total sum of utility values of results multiplied by their expected
probabilities. In utility theory, rational investors are assumed to be able to clearly define their choices
among any two options. The theory also assumes that investors make decisions consistently and
independently of other choices. Finally, utility theory assumes that investors have continuous
indifference curves and that they will make the same decisions when unfavorable outcomes are
combined or weighted with more favorable outcomes.
Its clear that the normative assumptions that traditional finance and utility theory use
dont apply to the way most investors make decisions and allocate capital. Its clear
that investors are not rational, and they dont make consistent and independent

decisions. In the next articles, we will explain why this is the case and how to properly
define and understand investor behavior.