What is behavior finance? Discuss how it differs from standard/classical finance

Answer :

Behavioral Finance Behavioral finance is a relatively new and emerging topic in the area of finance, with its origins in the psychological study of human decision making. In short, behavioral finance is the study of the psychology of investors when making investment choices.

Standard Finance, sometimes referred to as modern portfolio theory has foundation blocks which states that investors are rational and markets are efficient and investors should construct their portfolios in accordance with the mean variance rules. It also believes that projected returns are a function of risk alone.

How Standard finance differs from Behavioral finance?

Standard finance assumes a linear risk - return relationship; which means that if risk increases, the return will also increase, but behavioral finance implies that there is an inverse relationship between perceived risk and perceived return.

Standard finance considers risk as an objective concept that can be quantified and can be calculated. However, behavioral finance claims risk to be subjective and it cannot be objectively measured.

Standard finance considers that a decision maker is rational. On the other hand, behavioral finance suggests decision makes is irrational.

Standard finance believes in the consistency of decisions and considers that the behavior of decision makes is also constant. Behavioral finance, on the other hand, argues that decisions will be inconsistent as there are several factors affecting the decision.