Traditional Finance Vs Behavioral Finance

Traditional Finance

Traditional Finance refers to a loan or credit obtained by a financial institution through conventional terms. Four Cs- capital, collateral, character and capacity are used here. The process to obtain finance is standardized as lenders look at your business, credit history and assets for qualifications.

Source - fundingcircle.com

Sources of Traditional Finance

The most traditional source is a large or small bank. Obtaining loan approval from large banks is hardest as application process relies on numerical facts like your credit score. Smaller banks have higher interest rates but work out to find a way to give loan. Small Business Administration can be approached for an SBA-backed loan. Getting the SBA guarantee reduces risk for the lender and these loans are very popular and competitive. Credit Unions also offer financing. It is a non-profit firm owned by members. Local area residents or educated associates can only join credit unions. Credit unions can offer low interest rates but do not enjoy trade benefits.

Pros and Cons of Traditional Finance

Traditional loans have competitive interest rates and is best for small businesses. Strong business, good credit and good capital as a low-risk borrower should use traditional finance. The disadvantage is that the approval process is very complex. Many rejections are to be faced before financing.

Source - ecosocsources

Behavioral Finance

It is a sub-set of behavioral economics. Biases and psychological factors affect financial decisions of investors. Market anomalies such as big rise and fall in stock prices happen because of influences. Loss aversion, familiarity tendency, and consensus bias are common. Irrational emotions arise and the fair price of all equities under market theory is flawed.

Concepts of Behavioral Finance

Mental Accounting- It is the practice to allocate money for specific reasons

Herd Behavior- People tend to copy the financial behavior of herd of investors

Emotional Gap- Decisions based on anger, fear or anxiety.

Anchoring- Spending according to a budget or to satisfy different utilities.

Self-attribution- It means decisions based on over-confidence

Biases of Behavioral Finance

Confirmation bias- It means accepting information that matches their prior-belief.

Experiential Bias- It means that investors believe that recent market happenings will continue in the future.

Loss Aversion- It means the tendency to put more weight on losses and ignore the pleasure of gains.

Familiarity Bias- Investors invest based on their prior knowledge and experience. They don’t take new risks or investment avenues.


Differences and Similarities between Traditional and Behavioral Finance

In traditional finance, an investor is a rational person who processes all information in an unbiased way. In behavioral finance, investors draw from real-world experience as he is an irrational person with biases and his emotions drive investment decisions. Example, a student needs writing help from a website and there are two companies- a local and a foreign. He will choose the local company because of his overconfidence and familiarity with the local firm, although the foreign company has a better diary.

Complete rationality theory applies in traditional finance. There is unlimited knowledge, data and perfect information. In behavioral finance, we have bounded rationality theory. Investors don’t need all information, and despite the accuracy of knowledge, they make mistakes in decisions.

In traditional finance, the market is efficient and represents the financial market’s true valuation. This is because investors have self-control. Market anomalies exist in behavioral finance because of volatile markets. Investors do not have complete self-control and so limitations prevail. Inconsistent market leads to severe rise and fall in market prices.

Behavioral finance is connected with normal pattern observed in the decisions of investors. Traditional finance relies on mathematical calculations, market observations and economic behavior.

Behavioral finance is based on the thinking capacity of investors while traditional finance is based on assumptions, theories and models.

Both traditional and behavioral finance is concerned with the stock market and the nature of investors.Both traditional and behavioral finance have decisions surrounding investments.

Behavioral finance looks into research. Traditional finance happens for a very long time period and is normative based on rules and universal expectations.

Conclusion

In recent years, there has been an increasing interest in behavioral finance to better understand how investors make decisions. This has led to the development of new investment strategies incorporating behavioral insights. On the other hand, traditional finance is more precise and organized but may make irrational assumptions about people’s behavior.

Written by - Amaan Goenka

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