Behavioral Approach versus Neoclassical Finance

This chapter confronts the main foundations of the neoclassical theory of finance with allegations of the behavioral approach. Theoretical models of classical financial economics do not take into account the possibility of decision maker irrationality. It is often assumed that irrational investors are not coordinated and therefore their behavior cancels out. And even if irrationality becomes strong and common among a large group of investors, it will be voided by rational actions of arbitrageurs. However, behavioral finance points out limits to arbitrage. It is argued that irrationality of investors may indeed influence asset pricing. This position challenges the main theoretical foundations of the neoclassical paradigm, including the Markowitz’s portfolio theory, traditional asset pricing models, and the Efficient Market Hypothesis. The behavioral approach is of high importance also for the second side of capital market, that is issuers. A discussion on key elements of corporate finance policy in the light of behavioral implications concludes the first chapter.