Financial theory all over the world is shrouded in rationalism. Every economics and finance textbook begins with the assumptions that man is a rational animal. They also assume that all the information is present with the investor and he can process it correctly. However, in reality, this is not the case.
When it comes to finance, there are staggering differences between theory and practice. This is due to the fact that theory has been written to be mathematical and to reach equilibrium. However, in reality, there is none. Here Are Some Unreasonable Assumptions of Conventional Financial Theory:
1) Investors clearly know their goals: Almost all financial textbooks assume that investors clearly know their financial goals. Almost no one is absolutely sure what they want their financial state to be at any given point of time. Words such as, more, rich and wealthy, are used when investors are asked to define their investment goals.
2) Investors weigh alternative options: Theories assume that investors will weigh all their options before they come to a conclusion regarding the investment decision they are making. However, in reality, the average Joe will invest because his cousin average Jack suggested him to do so. He never really considered all the options that he had.
3) Investors Calculate Risk and Use Odds: Neither do investors have the time nor the inclination to get involved in complex mathematics. Investing decisions are taken on the feet and require training.
Behavioral Finance As An Alternative Approach:
Therefore, an alternate science of study called behavioral finance has come into existence.