Traditional finance, market and price models assume markets are rational, it’s further assumed that this rationality is reflected in the intrinsic value of the security. The whole concept of traditional finance revolves around assumption people are ‘rational’ be it efficient market hypothesis, Bayes Theory, or what Markowitz said. But how often do we use into these theories in real world, how many people actually use Bayes Theorem to really update probabilities based on new information, probably very few. The underlying premise of traditional finance “Man is a ration being” is a hypothesis that has been proved wrong on many occasions. Each person has their individual rationale in what they do and same is true in sphere of investing as well, so it's hard not to think of the stock market as a person as well: it has moods that can turn from irritable to euphoric; it can also react hastily one day and make amends the next.
Can we understand the financial markets if it is not all that rational? Behavioral Finance attempts to fill the void that cannot be captured plausibly in traditional finance models based on perfect investor rationality.
Behavioral finance is about what people actually do i.e. actual investor behavior, actual market behavior and try to explain that. It challenges the rational investor assumption; it also challenges the efficient market hypothesis. Behavioral Finance makes certain assumptions, few of them are -
1. Aversion to Loss
Investors are strongly averse to risk and will only take them if expected returns are high and compensate them for the risk.
Daniel Kahneman and Amos Tversky came up with a study on how people react to risk called the Prospect Theory. The theory outlines how individuals react differently in undertaking risk for gains and when they concern losses.
Kahneman explains this with an example. A group of Princeton students were asked to take a bet where if they tossed the