Before we go over the specific concepts behind behavioral finance, let's take a more general look at this branch of finance. In this section, we'll examine how it compares to conventional finance, introduce you to three important contributors to the field and take a look at what critics have to say.
Why is behavioral finance necessary?
When using the labels "conventional" or "modern" to describe finance, we are talking about the type of finance that is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These theories assume that people, for the most part, behave rationally and predictably.
For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational financial theories did a respectable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn't be explained by theories available at the time. While these theories could explain certain "idealized" events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.