Behavioural Finance - Idealizations in Financial Theory and the Nature of Behavioral Finance

Idealizations in Financial Theory and the Nature of Behavioral Finance:

A Teaching Note - Frans Tempelaar

Financial-economic theory is fundamentally based on an idealizing concept of the functioning of financial markets and of the rational role of those who act in these markets. We may define the financial system as the collectivity of financial markets and financial institutions, including the financial instruments that are being used and traded therein. In general terms, financial instruments are contracts that generate one or more future - and therefore, in general, uncertain - payoffs. The concept of a capital market can be defined in a formal sense as the set of factors that determine the demand for and supply of long-term financial instruments. For example, one can think of the system of primary stock-issue markets and secondary stock exchanges.

Rationality implies an individual decision behavior, which refers to the intrinsic quality of judgment and decision making. Rationality is a relative concept and a rational behavior implies consistency, efficiency, effectiveness, and goal orientation.

According to unbounded rationality theory, the decision makers are guided by a single and well defined objective, is capable of making an unbiased and constant evaluation of all the relevant information. This is an idealized picture.

Bounded rationality, of rationality with limitations, says that human decision making is subject to limitations, meaning that the information available is limited, as well as are the knowledge of objectives and the capacity to process and evaluate information.

'Rationality' in financial theory is essentially equivalent to unbounded rationality.

The capital market is considered to be unbounded: aggregate results of the collective activity of decision makers in the market are considered to be rational. "a market actually populated by rational beings is observationally equivalent to a market characterized by grossly irrational individual behavior that cancels out in the aggregate, leaving the trace of the only systematic behavioral component, the small thread of rationality that all individuals have in common" (cited from Thaler). Rational capital market is an idealized concept.

Market perfection: ideal economic environment in which the market forces of finance are being exposed in their purest form. It assumes that there is complete diffusion of economic power among market participants( perfect competition - no influence from individual participation on market prices) and that market's transactions mechanism is frictionless.(fully transparent market, no transaction costs- infinitely divisible securities, no further restrictions on security transactions).

No arbitrage equilibrium = simultaneous buying and selling