Traditional and Behavioural Approach to Risk in Finance

Abstract

Abstract Making financial decisions under risk and uncertainty has become part of everyday life. Traditional finance explores the objective side of risk, analysing the decisions made by perfectly rational individuals in efficient market conditions. Behavioural finance seeks to connect theory with practice by combining elements of behavioural psychology with finance. The centre of interest of this theory is an individual with limited cognitive abilities and the tendency to make rational choices. The paper presents the risk component of financial and investment decisions from behaviour finance view point. In addition to precise “objective” measures, when expressing risk, subjective elements should be considered – investors’ risk perception and risk attitudes. This paper aims to highlight the key characteristics of the subjective elements of risk to obtain a full picture of the outcomes of financial decision-making. Based on the analysis of theoretical and empirical studies, we define challenges, as well as recommendations to individual investors regarding the influence of psychological factors when making investment decisions.