Traditional finance theory Vs. Behavioral finance theory

Abstract

According to traditional finance theorists, in an efficient market, investors think and behave "rationally" when trading, buying, and selling stocks, and each investor considers carefully all available information before making any trading or investment decisions. The theory of the financial market efficiency or efficient market hypothesis (EMH) corresponds to the theory of competitive equilibrium applied to the financial securities market. Indeed, efficiency assumes the atomicity of the market actors and that all the participants are in active competition with the aim of maximizing profits, so that none of them can alone influence the level of prices which will establish themselves in the market.

However, behavioral finance, whose main purpose is to study the real behavior of investors in the financial markets, based on social and cognitive psychology, has come to demonstrate with convincing evidence that investors make major systematic errors and that psychological biases affect investors' investment decision-making. In other words, behavioral finance claims that investors tend to have psychological and emotional biases that lead to making irrational investment decisions.

In this article, we will try in the first part to examine the nature and the extent of knowledge on the theory of the financial markets efficiency, one of the fundamental paradigms in traditional finance. Despite its considerable contribution to economic and financial theory, it has been hotly contested in recent years. In the second part, we will focus on the theory of behavioral finance, its main theory (prospect theory), its main biases and heuristics as well as its contribution and its limits.

JEL Classification: G41

Paper type: Theoretical Research