Modern Financial Theory and Behavior

Financial literacy is essential in today’s fast-paced, interconnected world. The terms “financial,” “finance” and “capital,” do not always refer to the same thing. Financial planning is an important component of overall personal and family financial security. As a result, the three words “financial,” “finances,” and “capital” are often used interchangeably.

Finance is a generic term for all things concerning the management, production, and allocation of capital and funds. There are four broad perspectives on the study and management of funds: behavioral finance, fundamental economics, institutional finance, and investment psychology. These various approaches reflect distinct approaches to the science of funds management. The goal of this book is to teach and illustrate the important differences between these perspectives as well as provide practical applications for improved decision making. This book also utilizes basic case studies from around the world to illustrate theoretical concepts.

Behavioral finance is the study of how people interpret and respond to financial situations. It is concerned with why people choose one financial option over another and why they make sub-optimal decisions in other cases. Fundamental economics deals with the processes that lead up to investment decisions. Institutional finance studies the interactions among financial institutions and individuals and their willingness to lend and borrow.

Behavioral finance is strongly influenced by two main research models. The first is bargaining theory, which states that people are motivated to save money for the long-term even when they face short-term expenses. The second is behavioral ontology, which assumes that individuals base their budgeting decisions on future incomes from employment, earnings, and savings. The information presented here can help individual’s budget their finances. As a result, a successful financial plan should include adequate funding for both short-term expenses and long-term investments to provide a secure financial foundation.

Another model used by financial planners is financial literacy. Financial literacy is the ability to understand and use the concepts of budgeting, savings, investing, borrowing, spending, and credit. Learning about these concepts requires both educating individuals and providing knowledge about current events. A financial planner who wishes to be successful must master financial literacy and develop expertise in applying it to personal finance.

A strong combination of behavioral finance knowledge and other modern financial theories is necessary for a truly effective financial planning process. In fact, a lack of knowledge about any one of these concepts may actually result in financial losses. Therefore, a financial planner should take all steps necessary to learn every concept he or she can handle. A good planner will always have a plan that meets the needs of his or her client, while still providing enough flexibility to adapt to changing circumstances.