Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 1 BEHAVIORAL FINANCE vs TRADITIONAL FINANCE Nik Maheran Nik Muhammad Faculty of Business Management Universiti Technology Mara, Kelantan nmaheran@gmail.com Abstract Behavioral finance models often rely on a concept of individual investors who are prone to judgment and decision-making errors. This article provides a brief introduction of behavioral finance, which encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets. The article also reviews prior research and extensive evidence about how psychological biases affect investor behavior and prices. The paper found that the most common behavior that most investors do when making investment decision are (1) Investors often do not participate in all asset and security categories, (2) Individual investors exhibit loss-averse behavior, (3) Investors use past performance as an indicator of future performance in stock purchase decisions, (4) Investors trade too aggressively, (5) Investors behave on status quo, (6) Investors do not always form efficient portfolios, (7) Investors behave parallel to each other, and (8) Investors are influenced by historical high or low trading stocks. However, there are relatively low- cost measures to help investors make better choices and make the market more efficient. These involve regulations, investment education, and perhaps some efforts to standardize mutual fund advertising. Moreover, a case can be made for regulations to protect foolish investors by restricting their freedom of action of those that may prey upon them. Keywords: Behavioral finance; Efficient Market Hypothesis; Investors psychology; Arbitrage; Rationality. 1. INTRODUCTION According to economic theorists, investors think and behave “rationally” when buying and selling stocks. Specifically investors are presumed to use all available information to form “rational expectations” about the future in determining the value of companies and the general health of the economy. Consequently, stock prices should accurately reflect fundamental values and will only move up and down when there is unexpected positive or negative news, respectively. Thus, economists have concluded that financial markets are stable and efficient, stock prices follow a “random walk” and the overall economy tends toward “general equilibrium”. In reality however, according to Shiller (1999) investors do not think and behave rationally. In the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors are misled by extremes of emotion, subjective thinking and the whims of the crowd, consistently form irrational expectation for the future performance of companies and the overall economy such that stock prices swing above and below fundamental values and follow a some what predictable, wave-like path. Investors behavior is part of academic discipline known as “behavioral finance” which explains how emotions and cognitive errors influence investors and the decision- making process. Behavior of the individual investors has long been the interest of academics and portfolio managers but not