Faults of Classic Financial Models

Abstract

Research in behavioural economics has increasingly offered arguments for how we as humans react when faced with both obstacles and enabling factors, and thus theories were formed that capture the individual characteristic of not acting in a rational and optimal manner when a certain decision is made. The increasing number of studies performed in behavioural finance can be utilized to aid the investor to be aware of the pitfalls of their own behavioural issues, and act with the knowledge of the existence of these issues. The human mind is mouldable both from internal and external factors when beliefs and expectations are formed, all influenced by the psychological aspects that each one of us carries, however knowing how these influences can be countered can become a strength.
These irrationalities are in classical economic theories not accounted for, and questions of the relevance of these theories has been brought to light as we expand the horizon for how big the impact of these subjects are when considering real developments in the financial markets. The classical theories are built on several factors to simplify them, but also to have them include variables that are measurable and are not restricted to national law, such as taxes. With the inclusion of factors which we cannot retrieve in reality, these theories can be considered more as a theoretical framework for understanding how the factors affect, and less of model to use when a precise result is obtained. Although no models can predict the impact of the human psychology on the financial market, this paper attempts to display selected theories which I believe to be of great importance when considering this impact on the stock market, but it also includes a behavioural variable into a classical model, to examine whether it is possible to improve the ability to predict a better expected return than the classical models.