Assumptions of Conventional Finance Theory
Conventional finance theory, also known as traditional finance or standard finance, provides a framework for understanding how financial markets and investments work. It relies on a set of core assumptions about human behavior and market conditions. While these assumptions have been influential in shaping modern finance, they are increasingly challenged by behavioral finance and real-world observations.
Key Assumptions:
- Rationality: This is perhaps the most fundamental assumption. It posits that investors are rational actors who make decisions to maximize their expected utility or wealth. This means they carefully weigh the costs and benefits of each investment, using all available information to make the most optimal choices for themselves. Errors are random and cancel out in the aggregate.
- Efficient Markets: Conventional finance assumes that markets are efficient, meaning that asset prices fully reflect all available information. This implies that it is impossible to consistently achieve above-average returns by using publicly available information, as prices quickly adjust to reflect any new data. This principle forms the basis of the Efficient Market Hypothesis (EMH), which has several forms (weak, semi-strong, and strong).
- Risk Aversion: While investors seek to maximize returns, they are also assumed to be risk-averse. This means that, all else being equal, investors prefer less risk to more risk. Therefore, they require higher expected returns to compensate for taking on additional risk. This risk-return trade-off is central to portfolio theory and asset pricing models.
- Independence of Decisions: Traditional finance assumes that investors make decisions independently of one another. Their choices are based on their own analysis and risk preferences, without being influenced by the emotions or actions of other investors. This assumption is crucial for market efficiency, as it prevents herding behavior and bubbles.
- Known Probability Distributions: Standard finance often assumes that the probability distributions of asset returns are known or can be accurately estimated. This allows for the use of statistical models to calculate expected returns, volatility, and other risk measures. The normal distribution is frequently used, which has been questioned.
- No Arbitrage: A core tenet is the absence of arbitrage opportunities. An arbitrage opportunity is a risk-free profit that can be made without any investment. In efficient markets, arbitrage opportunities are quickly exploited and eliminated, ensuring that prices reflect true value.
These assumptions provide the foundation for many financial models and theories, such as the Capital Asset Pricing Model (CAPM), portfolio optimization, and option pricing models. However, it is important to recognize that these are simplifications of reality. Behavioral finance has shown that individuals are often irrational, that markets can be inefficient, and that psychological biases can significantly impact investment decisions. While conventional finance remains a valuable tool, it is essential to be aware of its limitations and to consider alternative perspectives when analyzing financial markets.
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