Early Concepts and Theories

This chapter analyses the fundamental principles of conventional finance, including the efficient market hypothesis (EMH), modern portfolio theory (MPT), and arbitrage pricing theory (APT), which have traditionally informed the comprehension of financial markets and investor conduct. These theories are based on the premise of rationality, which posits that investors digest information perfectly and that markets efficiently represent all available information. Although these models have made substantial contributions to portfolio creation, asset pricing, and risk management, their shortcomings become more apparent when confronted with enduring market oddities and behavioural inconsistencies. The chapter rigorously assesses the deficiencies of these conventional paradigms, especially their failure to explain phenomena such as market overreactions, speculative bubbles, and other departures from rational expectations. This discussion shifts to an examination of behavioural finance, including psychological concepts such as prospect theory, mental accounting, anchoring, overconfidence bias, and herd behaviour. These frameworks demonstrate the significant impact of cognitive biases and emotional reactions on financial decision-making, questioning the traditional beliefs of rationality and efficiency in financial markets. This chapter demonstrates the need of incorporating behavioural factors into finance theory via a combination of theoretical ideas and practical examples. This research provides a crucial foundation for comprehending the intricate relationship between rational models and actual human behaviour in financial situations.