Conventional finance theory, also known as traditional finance theory, provides the foundational framework for understanding how markets and investors *should* behave under idealized conditions. It rests on a set of core assumptions about rationality, efficiency, and risk aversion. A central tenet is the **Efficient Market Hypothesis (EMH)**. This theory proposes that asset prices fully reflect all available information. In its strongest form, strong-form efficiency, even insider information cannot be used to generate abnormal returns. Semi-strong form efficiency suggests public information is already incorporated, while weak form efficiency only prices past price data is priced-in. If the market is efficient, attempts to “beat the market” through active trading strategies are futile in the long run, as prices are already at their fair value. **Rationality** is another cornerstone. Investors are assumed to be rational economic actors, making decisions based on logical calculations and maximizing expected utility. They possess perfect information or can access it at minimal cost, allowing them to accurately assess risk and return. Cognitive biases and emotional influences are disregarded. **Risk aversion** dictates that investors prefer lower risk for a given level of return. They demand a higher expected return to compensate for bearing additional risk. This risk-return tradeoff is captured in models like the Capital Asset Pricing Model (CAPM). The **Capital Asset Pricing Model (CAPM)** provides a framework for calculating the expected rate of return for an asset or investment. It relates an asset’s risk (measured by its beta, reflecting its sensitivity to market movements) to its expected return. The model assumes a single market factor drives asset prices and that diversification eliminates unsystematic risk (company-specific risk). Investors are only compensated for bearing systematic risk (market risk). **Modern Portfolio Theory (MPT)**, developed by Harry Markowitz, emphasizes the importance of diversification in portfolio construction. It posits that investors can optimize their portfolios by combining assets with different risk-return characteristics to achieve the highest expected return for a given level of risk or the lowest risk for a given level of expected return. MPT uses statistical measures like variance and covariance to assess portfolio risk. Conventional finance theory provides a benchmark against which to measure real-world market behavior. It offers tools and models for asset pricing, portfolio optimization, and risk management. While it simplifies reality, it serves as a crucial starting point for understanding financial markets. However, the assumptions of rationality and efficiency have been challenged by behavioral finance, which acknowledges the role of psychological biases and emotional influences in investment decisions. Empirical evidence often contradicts the EMH, demonstrating that markets can be inefficient and investors can earn abnormal returns through specific strategies. Despite its limitations, conventional finance remains a cornerstone of financial education and practice, offering valuable insights into the fundamental principles of finance.
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