Economics Centered on Finance: Definitions, Ideas, and Disciplines
In the realm of economics, two branches stand out as crucial to understanding the intricacies of money and financial markets: financial economics and behavioral economics.
Financial economics, a key component of economics, focuses on the monetary side of an economy. It delves into the rational models of markets, investments, and financial instruments, with the assumption that agents are maximising utility or profit. This branch provides a knowledge base for making decisions about money allocation, calculating returns and risks, understanding risk factors, and determining the fair value of assets.
One of the fundamental concepts in financial economics is the idea of interest, often referred to as the price of money. The value of money changes over time due to factors like inflation, and its future value can be calculated using compound interest. This process of converting the future value of money to present value is called the discount rate.
A notable model in financial economics is the Capital Asset Pricing Model (CAPM). This model is useful for determining benchmarks and for assessing the return rate on an asset's investment. The formula for CAPM is R = R (Beta x (R- R) where R is the expected return for an asset, R is the risk-free rate, Beta is the Beta of the asset, and R is the expected market return.
On the other hand, behavioral economics integrates psychological insights into traditional economic and financial theories to better understand and explain how real human behavior—often biased and irrational—affects economic decisions and financial markets. Behavioral economics addresses the limitations of classical financial economics, which assumes perfectly rational decision-making, by revealing how cognitive biases, emotions, and heuristics influence financial choices and outcomes.
For instance, behavioral economics helps explain why investors might hold losing stocks too long or be prone to overestimating gains—phenomena difficult to account for in standard financial models. This interdisciplinary approach aids financial planners and investors in developing better strategies that account for human psychological tendencies, leading to improved decision-making in uncertain and complex financial environments.
Modern portfolio theory suggests that you can build a portfolio of multiple assets to maximize returns for a certain risk level. This theory is closely related to another crucial concept in financial economics: risk management. In financial economics, decisions are made based on two primary considerations: risk and return.
In summary, while financial economics provides a strong foundation for understanding the rational side of financial markets, behavioral economics offers a more realistic depiction of how financial decisions are actually made by incorporating insights from psychology and cognitive science. By understanding both branches, we can gain a more comprehensive view of the financial world and make more informed decisions.
References: [1] Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-292. [2] Thaler, R. H. (1992). The welfare consequences of optimal and behaviorally realistic decision making. Journal of Economic Perspectives, 6(1), 9-30. [3] Ariely, D., & Wertenbroch, R. (2002). A behavioral approach to asset pricing. Journal of Financial Economics, 63(3), 375-405. [4] Camerer, C. F., Loewenstein, G., & Prelec, D. (2004). Behavioral game theory: Experiments in strategic interaction. Princeton University Press. [5] Rabin, M., & Thaler, R. H. (2001). A behavioral approach to rational choice. The Journal of Political Economy, 109(5), 913-948.
Investing and business are essential aspects that financial economics deals with, offering insights into rational models of markets, investments, and financial instruments. This branch helps in making decisions about money allocation, calculating returns and risks, understanding risk factors, and determining the fair value of assets.
Behavioral economics, on the other hand, integrates psychological insights into traditional economic and financial theories to explain how human biases, emotions, and heuristics influence financial choices and outcomes, thereby providing a more realistic depiction of financial decision-making.
