Part a) Outline the key differences between standard finance theory and behavioral finance.
B ) Discuss the tendency for individuals to be overconfident and whether such a bias has a material impact on share prices.
Behavioral finance attempts to understand and explain observed investor and market behaviors. This differs from traditional (standard) finance, which is based on hypotheses about how investors and markets should behave. In other words, behavioral finance differs from traditional finance in that it focuses on how investors and markets behave in practice rather than in theory. By focusing on actual behavior, behavioral researchers have observed that individuals make investment decisions in ways and with outcomes that differ from the approaches and outcomes of traditional finance. As Meir Statman so succinctly puts it, “Standard finance people are modeled as “rational,” whereas behavioral finance people are modeled as “normal.” Normal people behave in a manner and with outcomes that may appear irrational or suboptimal from a traditional finance perspective. As a result of identified divergence between observed and theoretically optimal decision making, the global investment community has begun to realize that it cannot rely entirely on scientific, mathematical, or economic models to explain individual investor and market behavior.