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Why is There a Need for Behavioural Finance?

The lessons of modern economics and finance or "Neoclassical economics" are really about an ideal.

It is what happens, or should happen, if humans were able to leave their emotions behind when making decisions.

We are talking about Homo Economicus. According to modern economics, emotions, human fallibility and other extraneous factors do not influence people when it comes to making economic choices.

It is based on 3 major assumptions:

Rational Assumes participants are rational
Wealth Maximisers Assumes participants are wealth maximisers
Reflect Fair Value Assumes prices always reflect fair value

These assumptions feed some fundamental economic models such as the Capital Asset Pricing Model and the Efficient Market Hypothesis.

If these 3 assumptions were correct then markets should be efficient but participants – humans – are not always rational wealth maximisers and due to the errors caused by the first 2 points, prices can be affected and create less efficient markets.

Markets do go up and down. However, crashes and bubbles shouldn’t happen if people made rational decisions and markets were efficient. These events cannot be explained by modern economics alone, something else must be at work for events to occur. This is why a new theory was needed and thus the concept of investor psychology and Behavioural Finance was born.

There are many ways to describe what Behavioural Finance is all about, the cross-breed of psychology and economics, marrying the field of investments with biology and psychology or simply putting a human face on investing. No matter what label we attached to it, Behavioural Finance is the bridge between the “ideal” world of modern economics and finance or “Neoclassical economics” and the real world, where we find ourselves working and investing in today.

“Modern economic theory is very powerful, making specific predictions from a small number of technical assumptions but it can be mystified and come undone by the ordinary behaviour of ordinary people!”

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