Updated: Jan 31
The following article has been adapted from FME Articles, a partner organization of Finance OneforOne. To read a longer version of this article, click here.
Behavioral and traditional finances are the two main areas of finance. They differ in how they describe people's decision-making process but both are fundamental to everyday finances and investments.
Let’s start with behavioral finance. Psychology plays a vital role in behavioral finance because it determines how people make financial decisions. Behavioral finance takes real-world examples into account and states that people tend to make savings and investment decisions emotionally rather than rationally.
Meanwhile, in traditional finance, people are practical, and they make decisions based on mathematical calculations, economic models, market behavior, and other types of data. In other words, investors and consumers comprehend information unbiasedly, allowing them to make decisions carefully.
The difference between the two concepts occurs because, in traditional finance, people consistently gain knowledge, data, and various immaculate information. Since they are able to apprehend the situation precisely, their financial actions are exceptionally scrupulous.
However, we can all agree that no one possesses flawless information; this is what behavioral finance is based on. Behavioral finance states that it is impossible for people to process all information, implying that they do not act entirely rationally. In the real world, people do not act "by the numbers" but rather by what they "feel" is right.
Contrary to traditional finance, behavioral finance believes that emotions cause the world to be unpredictable, resulting in various anomalies such as an unexpected pandemic. Since emotions tend to alter constantly, it has a direct impact on the lives of decision-makers.
We conclude that traditional and behavioral finance differ eminently because behavioral finance advocates emotional decision-making, while traditional finance advocates rational decision-making. While the two fields differ in their ideologies, traditional finance and behavioral finance are both imperative to understanding personal finances and the economy. Traditional finance puts forth expectations for the financial world and the careful process that goes into making decisions about it; whereas, behavioral finance puts forward reality.